Heading Into Jackson Hole, by Tim Duy: The Kansas City Federal Reserve's annual Jackson Hole conference is next week, and all eyes are looking for signs that Fed Chair Janet Yellen will continue to chart a dovish path for monetary policy well into next year. Indeed, the conference title itself - "Re-Evaluating Labor Market Dynamics" - points in that direction, as it emphasizes a topic that is near and dear to Yellen's heart. My expectation is that no hawkish surprises emerge next week. Despite continued improvement in labor markets, Yellen will push the Fed to hold back on aggressively tightening monetary policy. And with inflation still below target, wage growth constrained, and inflation expectations locked down, she holds all the leverage to make that happen.

Today we received the June JOLTS report, a lagging, previously second-tier report elevated to mythic status by Yellen's interest in the data. The report revealed another gain in job openings, leading to further speculation that labor slack is quickly diminishing:

Anecdotally, firms are squealing that they can't find qualified workers. Empirically, though, they aren't willing to raise wages. Neil Irwin of the New York Times reports on the trucking industry as a microcosm of the US economy:

Yet the idea that there is a huge shortage of truck drivers flies in the face of a jobless rate of more than 6 percent, not to mention Economics 101. The most basic of economic theories would suggest that when supply isn’t enough to meet demand, it’s because the price — in this case, truckers’ wages — is too low. Raise wages, and an ample supply of workers should follow.

But corporate America has become so parsimonious about paying workers outside the executive suite that meaningful wage increases may seem an unacceptable affront. In this environment, it may be easier to say “There is a shortage of skilled workers” than “We aren’t paying our workers enough,” even if, in economic terms, those come down to the same thing.

The numbers are revealing: Even as trucking companies and their trade association bemoan the driver shortage, truckers — or as the Bureau of Labor Statistics calls them, heavy and tractor-trailer truck drivers — were paid 6 percent less, on average, in 2013 than a decade earlier, adjusted for inflation. It takes a peculiar form of logic to cut pay steadily and then be shocked that fewer people want to do the job.

A "peculiar form of logic" indeed, but one that appears endemic to US employers nonetheless. Meanwhile, from Business Insider:

Profit margins are still getting wider.

"With earnings growth (6.7%) rising at a faster rate than revenue growth (3.1%) in Q2 and in future quarters, companies have continued to discuss cost-cutting initiatives to maintain earnings growth rates and profit margins," said FactSet's John Butters on Friday.

This comes at a time when profit margins are already at historic highs.

Ever since the financial crisis, sales growth has been weak. However, corporations have been able to deliver robust earnings growth by fattening profit margins. Much of this has been done by laying off workers and squeezing more productivity out of those on the payroll.

Margins serve as a line of defense against inflation. In fact, I would imagine that Yellen's ideal world is one in which margins are compressing because stable inflation expectations prevent firms from raising prices while tight labor markets force wage growth higher. A goldilocks scenario from the Fed's perspective. This is also the scenario that is most likely to foster the tension in the FOMC as Fed's hawks argue for immaculate inflation while doves battle back about actual inflation. In any event, until wage growth actually accelerates, the likelihood of any meaningful, self-sustaining inflation dynamic remains very, very low.

Separately, a second justification for a moderate pace of tightening emerges. Via Reuters:

Approaching a historic turn in U.S. monetary policy, Janet Yellen has staked her tenure as chair of the Federal Reserve on a simple principle: she'd rather fight inflation than another economic downturn.

Interviews with current and former Fed officials indicate that Yellen and core decision-makers at the U.S. central bank are determined not to raise interest rates too early and risk hurting the fragile U.S. economy...

...The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession.

Gasp! Is the reality of the zero bound finally sinking in at the Fed? The basic argument is that the Fed needs to at least risk overshooting to pull interest rates into a zone that allows for normalized monetary policy during the next recession. And given that the Fed knows how to effectively tame inflation while stimulating the economy at the zero bound in more challenging, the costs of overshooting are less than the costs of undershooting.

(Note that I suspect overshooting in this context is the 2.25-2.5% range, but that still provides more leeway than a 2.25% cap.)

In addition, Yellen can point out that since the disinflation of the early 90's, the Fed has not faced an inflation problem, but instead has struggled with three recessions. This on the surface suggests that monetary policy has erred in being too tight on average.

Bottom Line: Anything other than a dovish message coming from the Jackson Hole conference will be a surprise. Tight labor markets alone will not justify an aggressive pace of tightening. An aggressive pace requires that those tight labor markets manifest themselves into higher wage growth and higher inflation. Yellen seems content to normalize slowly until she sees the white in the eyes of inflation.

Fed Hawks Squawk, by Tim Duy: How much leeway does Fed Chair Janet Yellen have in her campaign to hold interest rates low for a considerable period after asset purchases end later this year? If you listen to Fed hawks, you would believe that she is quickly running out of room. Dallas Federal Reserve President Richard Fisher argued that the liftoff date for interest rates is creeping forward. From Reuters:

"I think the committee, as I listen to them and I can only speak for myself around that table during two days of discussion, is coming in my direction, so I didn’t feel the need to dissent,” Dallas Federal Reserve Bank President Richard Fisher said on Fox Business Network.

"We are going to have to move the date of liftoff further forward than had been projected the last time we issued the 'dots'” he said, referring to the official Fed forecasts for short-term interest rates, last issued in June.

At the time of the June FOMC meeting, the most recent read on the unemployment rate was 6.3% (May), while the July rate was just a nudge lower at 6.2%. The inflation rate (core-PCE) at the time of the June FOMC meeting was 1.43% (April), compared to 1.49% in June. So the Fed is arguably just a little closer to its goals, but enough to dramatically move forward the dots just yet? Not sure about that, but a downward lurch of unemployment in the next report would likely elicit a reaction in the dots. If the dots don't move, Fisher promises a dissent at the next FOMC meeting.

The pace of the tightening, however, is in my opinion more important than the timing of the first rate hike. Richmond Federal Reserve President Jeffrey Lacker argues that the pace of rate hikes will be more aggressive than currently anticipated by market participants. Via Craig Torres at Bloomberg:

Investors may be underestimating the pace at which the Federal Reserve will raise interest rates over the next two years, said Jeffrey Lacker, president of the Federal Reserve Bank of Richmond.

Short-term interest-rate markets have for months priced in a slower tempo of increases than policy makers themselves forecast. That’s risky because the misalignment, a bet against a rate path that the central bank alone controls, could lead to volatility if traders have to adjust rapidly, Lacker said.

“When there is that kind of gap, it gets your attention,” Lacker, a consistent critic of the Fed’s record easing who votes on policy next year, said in an Aug. 1 interview at his Richmond office overlooking the James River. “It wouldn’t be good for it to be closed with great rapidity.”

How much should we listen to Lacker? Torres notes correctly that Lacker's track record on policy is not exactly the greatest:

Lacker’s forecasts haven’t always been on target, which he’s acknowledged in his speeches. In a March 2012 dissent, he indicated the federal funds rate would have to rise “considerably sooner” than late 2014 “to prevent the emergence of inflationary pressures,” according to minutes of the meeting. The benchmark rate is still close to zero, and inflation is below the Fed’s target.

Where to begin? First, it is worth dispensing with the myth of "immaculate inflation." Fed hawks seem to believe that low unemployment is sufficient to send inflation screaming higher. They see the 1970s under ever carpet, behind every closet door. But the relationship between unemployment and inflation is simply very weak:

Generally, inflation has been within a range of 1.0% to 2.5% since the disinflation of the early 1990s. No immaculate inflation. What is missing to generate that immaculate inflation? Inflation expectations. After the decline in inflation expectations in the early 1980's:

inflation expectations have been remarkably stable:

As long as inflation expectations remain anchored, immaculate inflation remains unlikely. Stable inflation expectations thus clearly give Yellen room to pursue a less aggressive normalization strategy. Note that this does not mean waiting until inflation expectations begin to rise before tightening. Remember that the reason that inflation expectations remain anchored is because the Fed does in fact tighten policy in when conditions point toward above-target inflation. The Fed learned in the early 1980s that they do in fact have substantial control over inflation expectations, and they intend to retain that control. But without conditions that argue for a real threat to those expectations - including, notably, actual inflation above the 2.25% in the context of faster wage growth - Yellen will have justification to resist an aggressive pace of tightening.

Moreover, Yellen still has tepid wage growth on her side. And if unemployment dips below 6% as seem inevitable by the end of this year, I suspect we will move into a critical test of the Yellen hypothesis. Consider the relationship between wage growth and unemployment:

The downward slop looks obvious, but becomes even clearer if we isolate some of the movement associated with recessions:

At the moment, wage growth is on the soft side of where we might expect given the unemployment rate, consistent with Yellen's position. If that situation continues, then it follows that Yellen will have a strong hand to play with the FOMC. Lack of wage growth by itself would argue for a very gradual pace of rate hikes even in the face of higher inflation. Yellen - and the majority of the FOMC - will not see a threat to inflation expectations at the current pace of wage growth.

Bottom Line: At the moment, we are focused on wages as the missing part of the higher rate equation. But that is too narrow of an analysis. Also on Yellen's side is low actual inflation and anchored inflation expectations. To be sure, the Fed will be under increasing pressure to begin normalizing policy if unemployment drops below 6%. At that point the Fed will be sufficiently close to their objectives that they will believe the odds of falling behind the curve will rise in the absence of movement toward policy normalization. But without a more pressing threat to inflation expectations from a combination of actual inflation in excess of the Fed's target and wage growth to support that inflation, Yellen has room to normalize policy at a gradual pace. For now, the data is still on her side and the hawks will remain frustrated, much as they have for the past several years.

Long Road to Normal for Bank Business Lending, by Simon Kwan, FRBSF Economic Letter: Following the 2007–09 financial crisis, bank lending to businesses plummeted. Five years later, the dollar amount of bank commercial and industrial lending has finally surpassed the previous peak. However, despite very accommodative monetary policy and abundant excess reserves in the banking system, the spread of the commercial loan interest rates over the target federal funds rate remains above its long-run average. This suggests that business loans are not yet cheap relative to banks’ funding cost. ...[continue]...

Cash for Corollas: When Stimulus Reduces Spending, by Mark Hoekstra, Steven L. Puller, Jeremy West, NBER Working Paper No. 20349 Issued in July 2014: Cash for Clunkers was a 2009 economic stimulus program aimed at increasing new vehicle spending by subsidizing the replacement of older vehicles. Using a regression discontinuity design, we show the increase in sales during the two month program was completely offset during the following seven to nine months, consistent with previous research. However, we also find the program's fuel efficiency restrictions induced households to purchase more fuel efficient but less expensive vehicles, thereby reducing industry revenues by three billion dollars over the entire nine to eleven month period. This highlights the conflict between the stimulus and environmental objectives of the policy.

July Employment Report, by Tim Duy: The overall tenor of the July employment report was consistent with the song that Yellen and Co. are singing. Labor markets are generally improving at a moderate pace, yet despite relatively low unemployment, there is plenty of reason to believe considerable slack remains in the economy.

The headline nonfarm payroll number was a ho-hum gain of 209K with some small upward revisions for the previous two months. Steady above 200k gains this year are lifting the 12-month moving average of jobs higher:

In the context of the range of indicators that Fed Chair Janet Yellen has drawn specific attention to:

Consistent with the consensus of the FOMC as revealed at the conclusion of this week's FOMC meeting, measures of underutilization of labor remain elevated. Notable is the flat wage growth - clearly a ball in Yellen's court. Moreover, these numbers should override any enthusiasm over yesterday's ECI report, which is obviously overtaken by events.

In other news, inflation remains below target:

although pretty much right at target over the past three months:

Numbers like these gave the Fed reason to upgrade its inflation outlook this week. If these numbers can hold up for the next several months, you will see the year-over-year number gradually converge to the Fed's target, clearing the way for the Fed's first rate hike in the middle of next year (my preference remains the second quarter over the third).

On the whole, these data continue to argue for a very gradual pace of tightening. The Fed will be in rush to normalize policy until labor underutilization approaches normal levels and wage growth accelerates. Since it's Friday and everyone is looking forward to the weekend, we can avoid re-inventing the wheel on this topic and just refer to Binyamin Appelbaum's report on the FOMC meeting, in which he quotes some random commentator:

The Fed’s chairwoman, Janet L. Yellen, and her allies have taken a more cautious view, arguing that the decline in the unemployment rate appears to overstate the improvement in the labor market, because it counts only people who are looking for work. Ms. Yellen has said she expects some people who dropped out of the labor force to return as the economy continues to improve, and she has pointed to tepid wage growth as evidence that it remains easy to find workers.

“The recovery is not yet complete,” she told Congress this month.

The statement suggested that the committee continued to back Ms. Yellen’s view, said Tim Duy, a professor of economics at the University of Oregon.

“The committee as a whole is still willing to give Yellen the benefit of the doubt,” Mr. Duy said. “And honestly they have good reason. Until you get upward pressure on wages, it is terribly difficult to say that she’s wrong.”

In recent conversations with Oregon businesses, Mr. Duy said, he heard repeatedly that it was becoming harder to hire workers, but also that businesses were unwilling to offer higher wages as an inducement, because they doubted their ability to recoup the cost through increased sales or higher prices.

FOMC Statement, by Tim Duy: At the conclusion of this week's FOMC meeting, policymakers released yet another statement that only a FedWatcher could love. It is definitely an exercise in reading between the lines. The Fed cut another $10 billion from the asset purchase program, as expected. The statement acknowledged that unemployment is no longer elevated and inflation has stabilized. But it is hard to see this as anything more that describing an evolution of activity that is fundamentally consistent with their existing outlook. Continue to expect the first rate hike around the middle of next year; my expectation leans toward the second quarter over the third.

The Fed began by acknowledging the second quarter GDP numbers:

Information received since the Federal Open Market Committee met in June indicates that growth in economic activity rebounded in the second quarter.

With the new data, the Fed's (downwardly revised) growth expectations for this year remain attainable, but still requires an acceleration of activity that has so far been unattainable:

Despite all the quarterly twists and turns, underlying growth is simply nothing to write home about:

That slow yet steady growth, however, has been sufficient to support gradual improvement in labor markets, prompting the Fed to drop this line from the June statement:

The unemployment rate, though lower, remains elevated.

and replace it with:

Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources.

While the unemployment rate is no longer elevated, this is a fairly strong confirmation that Federal Reserve Chair Janet Yellen has the support of the FOMC. As a group, they continue to discount the improvement in the unemployment rate. And as long as wage growth remains tepid, this group will continue to have the upper hand.

The inflation story also reflects recent data. This from June:

Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable...The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

became this:

Inflation has moved somewhat closer to the Committee's longer-run objective. Longer-term inflation expectations have remained stable...The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.

Rather than something to worry over, I sense that the majority of the FOMC is feeling relief over the recent inflation data. It is often forgotten that the Fed WANTS inflation to move closer to 2%. The reality is finally starting to look like their forecast, which clears the way to begin normalizing policy next year. Given the current outlook, expect only gradual normalization.

Finally, we had a dissent:

Voting against was Charles I. Plosser who objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for "a considerable time after the asset purchase program ends," because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee's goals.

We probably should have seen this coming; Philadelphia Fed President Charles Plosser raised this issue weeks ago. Clearly he is not getting much traction yet among his colleagues. I doubt they want to change the language before they have settled on a general exit strategy (which was probably the main topic of this meeting and will be the next). Somewhat surprising is that Dallas Federal Reserve President Richard Fisher did not join Plosser given Fisher's sharp critique of monetary policy in Monday's Wall Street Journal. Note to Fisher: Put up or shut up.

Bottom Line: Remember that we should see the statement shift in response to the data relative to the outlook. In short, the statement needs to remain consistent with the reaction function. The changes in the July statement reflect that consistency. The data continues to evolve in such a way that the Fed can remain patient in regards to policy normalization. We will see if that changes with the upcoming employment report; focus on the underlying numbers, as the Fed continues to discount the headline numbers.

The Wage Growth Gap for Recent College Grads, by Bart Hobijn and Leila Bengali, FRBSF Economic Letter: Median starting wages of recent college graduates have not kept pace with median earnings for all workers over the past six years. This type of gap in wage growth also appeared after the 2001 recession and closed only late in the subsequent labor market recovery. However the wage gap in the current recovery is substantially larger and has lasted longer than in the past. The larger gap represents slow growth in starting salaries for graduates, rather than a shift in types of jobs, and reflects continued weakness in the demand for labor overall.

Starting wages of recent college graduates have essentially been flat since the onset of the Great Recession in 2007. Median weekly earnings for full-time workers who graduated from college in the year just before the recession, between May 2006 and April 2007, were $653. Over the 12 months ending in April 2014, the earnings of recent college graduates had risen to $692 a week, only 6% higher than seven years ago.

The lackluster increases in starting wages for college graduates stand in stark contrast to growth in median weekly earnings for all full-time workers. These earnings have increased 15% from $678 in 2007 to $780 in 2014. This has created a substantial gap between wage growth for new college graduates and workers overall.

In this Economic Letter we put the wage growth gap in a historical context and consider what is at its heart. In particular, we find that the gap does not reflect a switch in the types of jobs that college graduates are able to find. Rather we find that wage growth has been weak across a wide range of occupations for this group of employees, a result of the lingering weak labor market recovery.

College graduates’ wage growth gap in a historical perspective

We compare wages of recent college graduates to the overall population over time using monthly data at an individual level from the Current Population Survey (CPS). The CPS is used by the Bureau of Labor Statistics (BLS) to calculate the official estimates of the unemployment rate, employment, and median weekly earnings. The CPS does not specifically identify recent college graduates, so we define them as workers who have a college degree and are between ages 21 and 25.

Figure 1Median weekly earnings: Overall vs. recent graduates

Source: BLS/Haver Analytics, CPS, and authors’ calculations.

Figure 1 shows a comparison of full-time employees’ median weekly earnings for our CPS measure of recent college graduates and for the overall population, taken from the BLS. We use our results for graduates in the year before the recession began as a benchmark, indexing values to 100 in 2006:Q4. In this way, the lines after that point show by what percent median weekly earnings have grown since the recession started.

Typically, at least over the time period shown, the median weekly earnings of recent college graduates have tracked overall earnings relatively well, with some deviation. New graduates tend to exhibit stronger wage growth during economic booms, and slower wage growth in downturns (shown by gray bars) and subsequent recoveries. Put another way, wage growth for recent college graduates tends to fall during recessions and not pick up again until long into recoveries. In this context, the striking pattern we see since the 2007–09 recession is not without precedent. For example, a similar pattern would emerge if Figure 1 ended around the middle of 2005, in the later stages of the labor market recovery after the 2001 recession. Over this period, wage growth for recent graduates appeared to stall for a number of years after the recession, while overall wage growth continued to increase. Although the pattern in that earlier recovery is similar to recent years, wage growth for college graduates in the current recovery has remained flat for a longer period. Furthermore, the gap between the two groups of employees appears to be substantially wider and their paths appear more divergent.

Broad-based weakness in earnings growth

Even though the recent slow wage growth is not unprecedented, its apparent persistence raises the question of why it has remained so slow for so long. We explore two potential explanations. One is that recent graduates are now getting different types of jobs than they were before the recession, particularly jobs typically associated with lower wages and thus lower earnings. If this were true, comparing the occupational distribution of recent graduates before and after the recession should reveal a shift towards low-paid occupations and away from high-paid occupations, with reasonably stable earnings in each group. Another possibility is that recent college graduates are getting jobs in similar occupations as they did before the recession, but within each occupation, growth of starting wages has been slow. If this were the case, we would expect to see similar percentages of recent graduates in each occupation over time, but little wage growth within each occupation. Note that more recent graduates taking part-time jobs, which may generate lower weekly earnings, would not explain the gap in wage growth in Figure 1, which shows only full-time workers.

To explore our two potential explanations, we use the information about each respondent’s major occupation as reported in the CPS. For this and subsequent analysis, we redefine years as May of the prior year through April of the current year; this is to make the groups correspond more closely to annual cohorts of college graduates, who likely graduate starting in May. For example, 2014 runs from May 2013 to April 2014. We report data for three points in time: 2007, a year before the start of the recession; 2011, around the start of the recovery; and 2014, the most recent year of data available.

Table 1Recent graduates in occupations, labor markets

Table 1 presents the shares of recent college graduates employed in major occupations and according to labor market status. Occupational categories for full-time employment are rather broad, but they show recent college graduates were employed in a similar distribution of occupations before and after the recession. Notably, some of the changes between 2007 and 2011 were at least partially reversed by 2014, such as in the categories for professional and related occupations; management, business, and finance; office and administrative occupations; and “other” occupational skill groups, classified roughly according to Autor (2010). Although there have been some notable shifts towards a few categories such as service occupations, occupational distributions have remained generally stable. Next we turn to our second explanation, that recent college graduates are getting the same kinds of jobs, but at lower wages. The right side of the table presents median weekly earnings for recent college graduates. For 2007 the table shows the level of earnings, and the columns for 2011 and 2014 list the percent change relative to 2007. Also shown are overall earnings and earnings for recent graduates working part-time. With few exceptions, wage growth has been limited in all occupational groups for recent graduates. Note that professional and related occupations and management, business, and finance, which are the two most popular categories for recent graduates, have seen particularly low wage growth. The table also shows that earnings for recent graduates working part-time have fallen since the start of the recession, due to a combination of fewer hours worked and lower hourly wage growth.

Thus, while comparing occupational distributions across years indicates some stability, there is a clear pattern of low earnings growth for most categories. In fact, for almost all occupations and skill groups for which we have enough data to compare recent graduates to all others, we find that recent graduates experienced lower wage growth than other workers.

It turns out that the sluggish wage growth of recent college graduates is fully accounted for by the slowdown in wage growth across occupations. When we calculate a change in wages by keeping the types of jobs held by recent graduates fixed at their 2007 occupational composition, we find that wage growth is exactly the same as when we use the actual distribution.

Macroeconomic and individual-level implications

The broad-based weakness in earnings growth for recent college graduates has both larger economic and individual-level implications.

The wage growth gap points to continued weakness in the overall labor market. This is largely because recent college graduates are the “marginal” high-skilled workers in the economy, who are not protected by factors that make other workers’ wages rigid and slow to adjust to conditions such as recessions (see Hobijn, Gardiner, and Wiles 2011, who argue that this labor market weakness is cyclical rather than structural). Because the wages of recent college graduates are less affected by wage rigidity, they are a good indicator of the true price of labor and thus of the underlying state of the labor market.

Other signs of the continued weakness in the labor market are the shares of recent graduates not in the labor force, unemployed, or working part-time, which are still elevated compared with the start of the recession (see bottom of Table 1).

At the individual level, the persistent wage growth gap has implications for both recent graduates and potential graduates. Potential graduates, seeing the difficulties faced by current graduates in finding any job, particularly a full-time job, might interpret this as a signal that it is not worth going to college. However, recent evidence suggests that this is a misguided conclusion. It is important to note that the relevant metric for the returns of a college education accounts for the cost of education in comparing the earnings of college graduates relative to the earnings of nongraduates.

Low growth in starting wages does not mean that going to college is a poor investment. It just reflects that it will take longer to recoup the cost of the college education for current graduates. Supporting this idea, Kahn (2010) finds that those who graduate from college during a recession have lower earnings than other grads, even many years in the future. Taking into account the relative costs and benefits of a college education, Daly and Bengali (2014) find that a college education is still a very worthwhile investment, it may simply have relatively lower returns and take longer to pay off for recent graduates than for those who graduate during economic booms.

Conclusion

In this Letter we explore evidence that recent college graduates were and continue to be hit hard following the 2007–09 recession. The past several annual cohorts of graduates have experienced low earnings growth across almost all occupations compared with the overall population. While this post-recession pattern was also present after the 2001 recession, earnings growth following the most recent recession has been held down longer than in the past, which reflects the depth and severity of the recession. Because college grads face wages and hiring conditions that are especially responsive to business cycle conditions, this low earnings growth, together with shifts in the distribution of graduates’ labor market status, suggests continued weakness in the overall economy.

I think it will enhance the stability of the financial system. She thinks it will lead to instability. Well, at least we agree on the important issue.

What is it? Banks can have accounts at the Fed, called "reserves," and these accounts pay interest. In essence, the new program allows other financial institutions, that aren't legally "banks," to also have interest-paying accounts at the Fed. The program involves repurchase agreements, which is a bit silly -- who needs collateral from the Fed? -- but really think of it just as interest-paying bank accounts at the Fed.

I like the Fed's big balance sheet and interest-paying reserves, and I like opening up interest-paying reserves to everyone. I regard this as the first step to putting run-prone short-term financing out of business, by giving depositors a safe alternative. The Federal Government drove run-prone private banknotes out of business in the 19th century. Interest-paying reserves and Treasury floaters can drive run-prone interest-paying money out of business in the 21st. (This is the theme of "Toward a run-free financial system") Interest-paying money is not inflationary.

Blair does not like it. She is a voice worth hearing. ...[continue]...

That's the intent of a bill Republicans in the House of Representatives recently proposed. The Federal Reserve Accountability and Transparency Act would force the Fed's conduct of monetary policy to follow a prescribed rule...

Economists have long debated whether specific rules are better than giving central bankers the discretion to set monetary policy as they see fit. Here are the arguments for and against policy rules, and a compromise position that many economists advocate. ...

But now the Fed thinks the new tool will play no more than a “useful supporting role,” largely because of rising concerns about its potential effects on the financial system, according to the meeting minutes of the Fed’s June policy meeting and recent comments by Fed officials (who spoke before the week-long blackout period preceding their next meeting July 29-30). ...

Together, the minutes and officials’ remarks shed light on the Fed’s continuing internal debate over how to raise short-term interest rates from near zero, where they have been since late 2008. Officials are still weighing which tools to use and in what combination. ...[continue]...

Q&A: A Voice for an Activist Fed, NY Times: The Federal Reserve is often described as if it were a person – just one person – but it actually makes decisions by committee, and that committee is in flux. Only six of the 12 officials who voted on policy last January will still be voting when the Federal Open Market Committee holds its first meeting of 2014 this week.

Two new voters are likely to define the extremes of the debate as the committee charts the Fed’s continuing effort to revive the economy.

One is Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, perhaps the last official who wants the Fed to expand its efforts to reduce unemployment. Meanwhile, Richard Fisher, president of the Federal Reserve Bank of Dallas, is pressing for a faster retreat.

Mr. Kocherlakota and Mr. Fisher sat for separate interviews with The New York Times to talk about monetary policy and the economy this month before the media blackout that precedes each Fed meeting.

A transcript of Mr. Kocherlakota’s comments, edited for clarity, follows. [Mr. Fisher’s interview is in a separate post.]

The problem of stigma has been a lingering issue throughout the history of the DW. Prior to 2003, banks in distress could borrow from the DW at a rate below the fed funds target rate. Because of the subsidized rate, the Fed was concerned about “opportunistic overborrowing” by banks. Accordingly, before accessing the DW, a bank had to satisfy the Fed that it had exhausted private sources of funding and that it had a genuine business need for the funds. Hence, if market participants learned that a bank had accessed the DW, then they could reasonably conclude that the bank had limited sources of funding. The old DW regime therefore created a legitimate perception of stigma.

To address such stigma concerns, the Fed fundamentally changed its DW policy in 2003. In Regulation A, as revised in 2003, the Fed classified DW loans into primary credit, secondary credit, and seasonal credit. Financially strong and well-capitalized banks can borrow under the primary credit program at a penalty rate above the target fed funds rate (rather than a subsidized rate, as in the past). Other banks can use the secondary credit program and pay a rate higher than the primary credit rate. Finally, seasonal credit is for relatively small banks with seasonal fluctuations in reserves. For banks eligible for primary credit, the new DW is a “no-questions-asked” facility. Namely, the Fed no longer establishes a bank’s possible sources and needs for funding to lend under the primary credit program. Instead, primary credit for overnight maturity is allocated with minimal administrative burden on the borrower. Hence, access to primary credit need not be motivated by pressing funding needs nor signal financial weakness. In other words, there’s no structural reason why stigma should be attached to the new DW.

Nevertheless, stigma concerns resurfaced in 2007 at the onset of the recent financial crisis. In fact, as adverse liquidity conditions in the interbank markets persisted at the end of 2007, the Fed had to put in place a temporary facility, the Term Auction Facility (TAF), which was specifically designed to eliminate any perception of stigma attached to borrowing from the DW. Further, as discussed in a previous post, there’s strong evidence that banks experienced DW stigma during the most recent financial crisis.

So why do banks still feel DW stigma? In a recent staff report, we explored different hypotheses related to factors that may exacerbate or attenuate DW stigma. To conduct our analysis, we compared the DW rate with the bids each bank submitted at the TAF between December 2007 and October 2008. As explained in our paper, it can be shown with a simple arbitrage argument that, absent DW stigma, a TAF bidder should never bid above the prevailing DW rate. We therefore interpreted a bank bidding above the DW rate as evidence of DW stigma. Then, we conducted an econometric analysis to identify a bank’s possible determinants of DW stigma. Among the various hypotheses we tested, we report here the most interesting.

Banks outside the New York District: A necessary condition for DW stigma to exist is that banks must believe there’s a chance their identities will be made public soon after they borrow from the DW. Although central banks don’t immediately disclose the borrower’s identity, it’s been argued that DW borrowers may be identified from the Fed’s weekly public report, in which DW borrowings aggregated by Federal Reserve District are published. This identification channel may be especially relevant for banks in smaller Districts. Indeed, DW borrowing by an institution in a smaller District may be easier to detect. To test this hypothesis, our study focused on the Second Federal Reserve District (which covers the New York region) — the largest of the twelve Federal Reserve Districts in terms of the number of banks supervised. Consistent with the hypothesis, our results showed that banks in the New York District were 14 percent less likely to experience DW stigma than their counterparts in smaller Districts.

Foreign banks: It’s also possible that foreign institutions with access to primary credit at the Fed are especially sensitive to DW stigma. Indeed, in contrast with their U.S. counterparts, foreign banks typically don’t have access to retail dollar deposits that are insured by the Federal Deposit Insurance Corporation. As a result, foreign banks must often rely on wholesale debt investors (such as money market funds), which are highly sensitive to credit risk. In other words, because their investors may be sensitive to any negative information, foreign banks may be particularly concerned about the risk of being detected taking a loan at the DW. Again, we found strong evidence to support this hypothesis. Specifically, our results suggested that branches and agencies of foreign banks were 28 percent more likely to experience DW stigma than their U.S. counterparts with otherwise similar characteristics.

Herding effect: Intuitively, DW stigma may be expected to reflect a coordination problem. If an institution is the only one borrowing at the DW, then it’s likely to be stigmatized. However, the stigma from accessing the DW should be lower if many other institutions do so at the same time. However, we found no support for this hypothesis. Specifically, our results suggested that the stigma attached to borrowing at the DW didn’t decline when more banks accessed it during the 2007-08 period. To explore this question in more detail, we also tested whether there’s a form of herding or contagion effect, whereby a bank’s DW stigma declines when more banks within its own peer group (as measured by asset size) go to the DW. Again, the results from our regressions provided no evidence of such a herding effect.

Market conditions: In times of financial crises, there’s often intense speculation about the health of various financial institutions. In particular, public news that may be considered negative (such as a bank visit to the DW that becomes public) is likely to be amplified beyond its informational content. As a result, banks may go to greater expense to avoid borrowing at the DW. One may therefore expect DW stigma to increase when financial markets become more stressed. To test this hypothesis, our study considered three variables that capture aggregate funding conditions and volatility in financial markets: the Libor-OIS spread, a stress indicator for the interbank and money markets; the VIX level, a measure of the forward-looking volatility of the U.S. stock market as implied by options prices; and the CDX IG index of CDS prices, a measure of economy-wide default probability. Consistent with the hypothesis, we found that DW stigma was positively related to each of the three measures of stress in financial markets.

In summary, our study provided a better understanding of the reasons why banks may feel DW stigma. In particular, we found that the incidence of DW stigma was higher for foreign banks, banks that could be identified more easily, and banks outside the New York Federal Reserve District, as well as after financial markets became stressed. In contrast, we found no evidence that DW stigma may be due to a lack of coordination among banks when accessing the DW.

Disclaimer The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.

Olivier Armantier is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Ms. Yellen’s testimony is likely to reinforce a sense of complacency among investors who regard the Fed as convinced of its forecast and committed to its policy course. She reiterated the Fed’s view that the economy will continue to grow at a moderate pace, and that the Fed is in no hurry to start increasing short-term interest rates.

A key reason that Yellen is in no hurry to tighten is her clear belief that an accommodative monetary policy is warranted given the persistent damage done by the recession:

Although the economy continues to improve, the recovery is not yet complete. Even with the recent declines, the unemployment rate remains above Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level. Labor force participation appears weaker than one would expect based on the aging of the population and the level of unemployment. These and other indications that significant slack remains in labor markets are corroborated by the continued slow pace of growth in most measures of hourly compensation.

Another reminder to watch compensation numbers. Without an acceleration in wage growth, sustained higher inflation is unlikely and hence the Fed sees little need to remove accommodation prior to reaching its policy objectives.

The only vaguely more hawkish tone was that identified by Applebaum:

But Ms. Yellen added that the Fed was ready to respond if it concluded that it had overestimated the slack in the labor market, a more substantial acknowledgment of the views of her critics than she has made in other recent remarks.

The exact quote:

Of course, the outlook for the economy and financial markets is never certain, and now is no exception. Therefore, the Committee's decisions about the path of the federal funds rate remain dependent on our assessment of incoming information and the implications for the economic outlook. If the labor market continues to improve more quickly than anticipated by the Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned. Conversely, if economic performance is disappointing, then the future path of interest rates likely would be more accommodative than currently anticipated.

Her choice of words is important here. Note that she does not say "If the labor market improves more quickly". Yellen says "continues to improve more quickly" which means that the economy is already converging towards the Fed's objective more quickly than anticipated by current forecasts. This is a point repeatedly made by St. Louis Federal Reserve President James Bullard in recent weeks. For example, via Bloomberg:

Federal Reserve Bank of St. Louis President James Bullard said a rapid drop in joblessness will fuel inflation, bolstering his case for an interest-rate increase early next year.

“I think we are going to overshoot here on inflation,” Bullard said yesterday in a telephone interview from St. Louis. He predicted inflation of 2.4 percent at the end of 2015, “well above” the Fed’s 2 percent target.

“That is a break from where most of the committee seems to be, which is a very slow convergence of inflation to target,” he said in a reference to the policy-making Federal Open Market Committee.

His picture:

With Yellen at least acknowledging this point, it brings into question whether or not the Fed should maintain its "considerable period" language:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends...

Fed hawks, such as Philadelphia Federal Reserve President Charles Plosser, increasingly see the need to remove this language from the statement, and for some good reason. The Fed foresees ending asset purchases in October and can reasonably foresee raising interest rates in the first quarter given the trajectory of unemployment. Hence it is no longer clear that a "considerable period" between the end of asset purchases and the first rate hike remains a certainty.

To be sure, there will be resistance to changing the language now - the Fed will want to ensure that any change is interpreted as the result of a change in the outlook rather than a change in the reaction function. But the hawks will argue that the communications challenge is best handled by dropping the language sooner than later - later might appear like an abrupt change and be more difficult to distinguish from a shift in the reaction function. This I suspect is the next battlefield for policymakers.

Bottom Line: A generally dovish performance by Yellen today consistent with current expectations. But notice her acknowledgement of her critics, and watch for the "considerable period" debate to heat up as October approaches.

The process commences even before the meeting begins with a Board of Governors staffer writing up a summary of the staff’s economic and financial analyses, which are delivered at the start of each meeting.

One officer from the Board’s Division of Monetary Affairs, chosen on a rotating basis, writes up the policy discussion, in part relying on a transcript that is ready by the day after the meeting. Other staff members review the summary before sending it to Fed officials during the week following the meeting.

The Fed’s chairman is the first policy maker to review the minutes. After receiving the Fed chief’s approval, the minutes are sent to all meeting participants for comments and a revised draft is prepared by the following week.

The final draft is ready by the end of the second week. The Fed officials who can vote on interest-rate moves–the seven-person Board of Governors and five of the 12 regional bank presidents–have about four calendar days to vote to approve the minutes. The voting period ends at noon the day before the minutes are released, 21 days after the meeting.

The Fed decided to start releasing minutes three weeks after policy meetings in late 2004. Before that, the minutes were released with a longer lag. In its earliest days, the Fed kept its minutes confidential and only released a “Record of Policy Actions” once a year. Over time, the Fed decided to release more information on a more-frequent basis.

The central bank now releases full transcripts of meetings with a five-year lag.

Extra Reading: Ben Bernanke: Five Questions about the Federal Reserve and Monetary Policy

Five Questions about the Federal Reserve and Monetary Policy, Speech, Chairman Ben S. Bernanke, At the Economic Club of Indiana, Indianapolis, Indiana, October 1, 2012: Good afternoon. I am pleased to be able to join the Economic Club of Indiana for lunch today. I note that the mission of the club is "to promote an interest in, and enlighten its membership on, important governmental, economic and social issues." I hope my remarks today will meet that standard. Before diving in, I'd like to thank my former colleague at the White House, Al Hubbard, for helping to make this event possible. As the head of the National Economic Council under President Bush, Al had the difficult task of making sure that diverse perspectives on economic policy issues were given a fair hearing before recommendations went to the President. Al had to be a combination of economist, political guru, diplomat, and traffic cop, and he handled it with great skill.

My topic today is "Five Questions about the Federal Reserve and Monetary Policy." I have used a question-and-answer format in talks before, and I know from much experience that people are eager to know more about the Federal Reserve, what we do, and why we do it. And that interest is even broader than one might think. I'm a baseball fan, and I was excited to be invited to a recent batting practice of the playoff-bound Washington Nationals. I was introduced to one of the team's star players, but before I could press my questions on some fine points of baseball strategy, he asked, "So, what's the scoop on quantitative easing?" So, for that player, for club members and guests here today, and for anyone else curious about the Federal Reserve and monetary policy, I will ask and answer these five questions:

What are the Fed's objectives, and how is it trying to meet them?

What's the relationship between the Fed's monetary policy and the fiscal decisions of the Administration and the Congress?

What is the risk that the Fed's accommodative monetary policy will lead to inflation?

How does the Fed's monetary policy affect savers and investors?

How is the Federal Reserve held accountable in our democratic society?

What Are the Fed's Objectives, and How Is It Trying to Meet Them? The first question on my list concerns the Federal Reserve's objectives and the tools it has to try to meet them.

As the nation's central bank, the Federal Reserve is charged with promoting a healthy economy--broadly speaking, an economy with low unemployment, low and stable inflation, and a financial system that meets the economy's needs for credit and other services and that is not itself a source of instability. We pursue these goals through a variety of means. Together with other federal supervisory agencies, we oversee banks and other financial institutions. We monitor the financial system as a whole for possible risks to its stability. We encourage financial and economic literacy, promote equal access to credit, and advance local economic development by working with communities, nonprofit organizations, and others around the country. We also provide some basic services to the financial sector--for example, by processing payments and distributing currency and coin to banks.

But today I want to focus on a role that is particularly identified with the Federal Reserve--the making of monetary policy. The goals of monetary policy--maximum employment and price stability--are given to us by the Congress. These goals mean, basically, that we would like to see as many Americans as possible who want jobs to have jobs, and that we aim to keep the rate of increase in consumer prices low and stable.

In normal circumstances, the Federal Reserve implements monetary policy through its influence on short-term interest rates, which in turn affect other interest rates and asset prices.1 Generally, if economic weakness is the primary concern, the Fed acts to reduce interest rates, which supports the economy by inducing businesses to invest more in new capital goods and by leading households to spend more on houses, autos, and other goods and services. Likewise, if the economy is overheating, the Fed can raise interest rates to help cool total demand and constrain inflationary pressures.

Following this standard approach, the Fed cut short-term interest rates rapidly during the financial crisis, reducing them to nearly zero by the end of 2008--a time when the economy was contracting sharply. At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy tool for dealing with economic weakness was no longer available. Yet, with unemployment soaring, the economy and job market clearly needed more support. Central banks around the world found themselves in a similar predicament. We asked ourselves, "What do we do now?"

To answer this question, we could draw on the experience of Japan, where short-term interest rates have been near zero for many years, as well as a good deal of academic work. Unable to reduce short-term interest rates further, we looked instead for ways to influence longer-term interest rates, which remained well above zero. We reasoned that, as with traditional monetary policy, bringing down longer-term rates should support economic growth and employment by lowering the cost of borrowing to buy homes and cars or to finance capital investments. Since 2008, we've used two types of less-traditional monetary policy tools to bring down longer-term rates.

The first of these less-traditional tools involves the Fed purchasing longer-term securities on the open market--principally Treasury securities and mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The Fed's purchases reduce the amount of longer-term securities held by investors and put downward pressure on the interest rates on those securities. That downward pressure transmits to a wide range of interest rates that individuals and businesses pay. For example, when the Fed first announced purchases of mortgage-backed securities in late 2008, 30-year mortgage interest rates averaged a little above 6percent; today they average about 3-1/2 percent. Lower mortgage rates are one reason for the improvement we have been seeing in the housing market, which in turn is benefiting the economy more broadly. Other important interest rates, such as corporate bond rates and rates on auto loans, have also come down. Lower interest rates also put upward pressure on the prices of assets, such as stocks and homes, providing further impetus to household and business spending.

The second monetary policy tool we have been using involves communicating our expectations for how long the short-term interest rate will remain exceptionally low. Because the yield on, say, a five-year security embeds market expectations for the course of short-term rates over the next five years, convincing investors that we will keep the short-term rate low for a longer time can help to pull down market-determined longer-term rates. In sum, the Fed's basic strategy for strengthening the economy--reducing interest rates and easing financial conditions more generally--is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly.

Last month, my colleagues and I used both tools--securities purchases and communications about our future actions--in a coordinated way to further support the recovery and the job market. Why did we act? Though the economy has been growing since mid-2009 and we expect it to continue to expand, it simply has not been growing fast enough recently to make significant progress in bringing down unemployment. At 8.1 percent, the unemployment rate is nearly unchanged since the beginning of the year and is well above normal levels. While unemployment has been stubbornly high, our economy has enjoyed broad price stability for some time, and we expect inflation to remain low for the foreseeable future. So the case seemed clear to most of my colleagues that we could do more to assist economic growth and the job market without compromising our goal of price stability.

Specifically, what did we do? On securities purchases, we announced that we would buy mortgage-backed securities guaranteed by the government-sponsored enterprises at a rate of $40 billion per month. Those purchases, along with the continuation of a previous program involving Treasury securities, mean we are buying $85 billion of longer-term securities per month through the end of the year. We expect these purchases to put further downward pressure on longer-term interest rates, including mortgage rates. To underline the Federal Reserve's commitment to fostering a sustainable economic recovery, we said that we would continue securities purchases and employ other policy tools until the outlook for the job market improves substantially in a context of price stability.

In the category of communications policy, we also extended our estimate of how long we expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015. That doesn't mean that we expect the economy to be weak through 2015. Rather, our message was that, so long as price stability is preserved, we will take care not to raise rates prematurely. Specifically, we expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens. We hope that, by clarifying our expectations about future policy, we can provide individuals, families, businesses, and financial markets greater confidence about the Federal Reserve's commitment to promoting a sustainable recovery and that, as a result, they will become more willing to invest, hire and spend.

Now, as I have said many times, monetary policy is no panacea. It can be used to support stronger economic growth in situations in which, as today, the economy is not making full use of its resources, and it can foster a healthier economy in the longer term by maintaining low and stable inflation. However, many other steps could be taken to strengthen our economy over time, such as putting the federal budget on a sustainable path, reforming the tax code, improving our educational system, supporting technological innovation, and expanding international trade. Although monetary policy cannot cure the economy's ills, particularly in today's challenging circumstances, we do think it can provide meaningful help. So we at the Federal Reserve are going to do what we can do and trust that others, in both the public and private sectors, will do what they can as well.

What's the Relationship between Monetary Policy and Fiscal Policy? That brings me to the second question: What's the relationship between monetary policy and fiscal policy? To answer this question, it may help to begin with the more basic question of how monetary and fiscal policy differ.

In short, monetary policy and fiscal policy involve quite different sets of actors, decisions, and tools. Fiscal policy involves decisions about how much the government should spend, how much it should tax, and how much it should borrow. At the federal level, those decisions are made by the Administration and the Congress. Fiscal policy determines the size of the federal budget deficit, which is the difference between federal spending and revenues in a year. Borrowing to finance budget deficits increases the government's total outstanding debt.

As I have discussed, monetary policy is the responsibility of the Federal Reserve--or, more specifically, the Federal Open Market Committee, which includes members of the Federal Reserve's Board of Governors and presidents of Federal Reserve Banks. Unlike fiscal policy, monetary policy does not involve any taxation, transfer payments, or purchases of goods and services. Instead, as I mentioned, monetary policy mainly involves the purchase and sale of securities. The securities that the Fed purchases in the conduct of monetary policy are held in our portfolio and earn interest. The great bulk of these interest earnings is sent to the Treasury, thereby helping reduce the government deficit. In the past three years, the Fed remitted $200 billion to the federal government. Ultimately, the securities held by the Fed will mature or will be sold back into the market. So the odds are high that the purchase programs that the Fed has undertaken in support of the recovery will end up reducing, not increasing, the federal debt, both through the interest earnings we send the Treasury and because a stronger economy tends to lead to higher tax revenues and reduced government spending (on unemployment benefits, for example).

Even though our activities are likely to result in a lower national debt over the long term, I sometimes hear the complaint that the Federal Reserve is enabling bad fiscal policy by keeping interest rates very low and thereby making it cheaper for the federal government to borrow. I find this argument unpersuasive. The responsibility for fiscal policy lies squarely with the Administration and the Congress. At the Federal Reserve, we implement policy to promote maximum employment and price stability, as the law under which we operate requires. Using monetary policy to try to influence the political debate on the budget would be highly inappropriate. For what it's worth, I think the strategy would also likely be ineffective: Suppose, notwithstanding our legal mandate, the Federal Reserve were to raise interest rates for the purpose of making it more expensive for the government to borrow. Such an action would substantially increase the deficit, not only because of higher interest rates, but also because the weaker recovery that would result from premature monetary tightening would further widen the gap between spending and revenues. Would such a step lead to better fiscal outcomes? It seems likely that a significant widening of the deficit--which would make the needed fiscal actions even more difficult and painful--would worsen rather than improve the prospects for a comprehensive fiscal solution.

I certainly don't underestimate the challenges that fiscal policymakers face. They must find ways to put the federal budget on a sustainable path, but not so abruptly as to endanger the economic recovery in the near term. In particular, the Congress and the Administration will soon have to address the so-called fiscal cliff, a combination of sharply higher taxes and reduced spending that is set to happen at the beginning of the year. According to the Congressional Budget Office and virtually all other experts, if that were allowed to occur, it would likely throw the economy back into recession. The Congress and the Administration will also have to raise the debt ceiling to prevent the Treasury from defaulting on its obligations, an outcome that would have extremely negative consequences for the country for years to come. Achieving these fiscal goals would be even more difficult if monetary policy were not helping support the economic recovery.

What Is the Risk that the Federal Reserve's Monetary Policy Will Lead to Inflation? A third question, and an important one, is whether the Federal Reserve's monetary policy will lead to higher inflation down the road. In response, I will start by pointing out that the Federal Reserve's price stability record is excellent, and we are fully committed to maintaining it. Inflation has averaged close to 2 percent per year for several decades, and that's about where it is today. In particular, the low interest rate policies the Fed has been following for about five years now have not led to increased inflation. Moreover, according to a variety of measures, the public's expectations of inflation over the long run remain quite stable within the range that they have been for many years.

With monetary policy being so accommodative now, though, it is not unreasonable to ask whether we are sowing the seeds of future inflation. A related question I sometimes hear--which bears also on the relationship between monetary and fiscal policy, is this: By buying securities, are you "monetizing the debt"--printing money for the government to use--and will that inevitably lead to higher inflation? No, that's not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size. Moreover, the way the Fed finances its securities purchases is by creating reserves in the banking system. Increased bank reserves held at the Fed don't necessarily translate into more money or cash in circulation, and, indeed, broad measures of the supply of money have not grown especially quickly, on balance, over the past few years.

For controlling inflation, the key question is whether the Federal Reserve has the policy tools to tighten monetary conditions at the appropriate time so as to prevent the emergence of inflationary pressures down the road. I'm confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. For example, the Fed can tighten policy, even if our balance sheet remains large, by increasing the interest rate we pay banks on reserve balances they deposit at the Fed. Because banks will not lend at rates lower than what they can earn at the Fed, such an action should serve to raise rates and tighten credit conditions more generally, preventing any tendency toward overheating in the economy.

Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to "take away the punch bowl" is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools. I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions.

How Does the Fed's Monetary Policy Affect Savers and Investors? The concern about possible inflation is a concern about the future. One concern in the here and now is about the effect of low interest rates on savers and investors. My colleagues and I know that people who rely on investments that pay a fixed interest rate, such as certificates of deposit, are receiving very low returns, a situation that has involved significant hardship for some.

However, I would encourage you to remember that the current low levels of interest rates, while in the first instance a reflection of the Federal Reserve's monetary policy, are in a larger sense the result of the recent financial crisis, the worst shock to this nation's financial system since the 1930s. Interest rates are low throughout the developed world, except in countries experiencing fiscal crises, as central banks and other policymakers try to cope with continuing financial strains and weak economic conditions.

A second observation is that savers often wear many economic hats. Many savers are also homeowners; indeed, a family's home may be its most important financial asset. Many savers are working, or would like to be. Some savers own businesses, and--through pension funds and 401(k) accounts--they often own stocks and other assets. The crisis and recession have led to very low interest rates, it is true, but these events have also destroyed jobs, hamstrung economic growth, and led to sharp declines in the values of many homes and businesses. What can be done to address all of these concerns simultaneously? The best and most comprehensive solution is to find ways to a stronger economy. Only a strong economy can create higher asset values and sustainably good returns for savers. And only a strong economy will allow people who need jobs to find them. Without a job, it is difficult to save for retirement or to buy a home or to pay for an education, irrespective of the current level of interest rates.

The way for the Fed to support a return to a strong economy is by maintaining monetary accommodation, which requires low interest rates for a time. If, in contrast, the Fed were to raise rates now, before the economic recovery is fully entrenched, house prices might resume declines, the values of businesses large and small would drop, and, critically, unemployment would likely start to rise again. Such outcomes would ultimately not be good for savers or anyone else.

How Is the Federal Reserve Held Accountable in a Democratic Society? I will turn, finally, to the question of how the Federal Reserve is held accountable in a democratic society.

The Federal Reserve was created by the Congress, now almost a century ago. In the Federal Reserve Act and subsequent legislation, the Congress laid out the central bank's goals and powers, and the Fed is responsible to the Congress for meeting its mandated objectives, including fostering maximum employment and price stability. At the same time, the Congress wisely designed the Federal Reserve to be insulated from short-term political pressures. For example, members of the Federal Reserve Board are appointed to staggered, 14-year terms, with the result that some members may serve through several Administrations. Research and practical experience have established that freeing the central bank from short-term political pressures leads to better monetary policy because it allows policymakers to focus on what is best for the economy in the longer run, independently of near-term electoral or partisan concerns. All of the members of the Federal Open Market Committee take this principle very seriously and strive always to make monetary policy decisions based solely on factual evidence and careful analysis.

It is important to keep politics out of monetary policy decisions, but it is equally important, in a democracy, for those decisions--and, indeed, all of the Federal Reserve's decisions and actions--to be undertaken in a strong framework of accountability and transparency. The American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayer resources.

One of my principal objectives as Chairman has been to make monetary policy at the Federal Reserve as transparent as possible. We promote policy transparency in many ways. For example, the Federal Open Market Committee explains the reasons for its policy decisions in a statement released after each regularly scheduled meeting, and three weeks later we publish minutes with a detailed summary of the meeting discussion. The Committee also publishes quarterly economic projections with information about where we anticipate both policy and the economy will be headed over the next several years. I hold news conferences four times a year and testify often before congressional committees, including twice-yearly appearances that are specifically designated for the purpose of my presenting a comprehensive monetary policy report to the Congress. My colleagues and I frequently deliver speeches, such as this one, in towns and cities across the country.

The Federal Reserve is also very open about its finances and operations. The Federal Reserve Act requires the Federal Reserve to report annually on its operations and to publish its balance sheet weekly. Similarly, under the financial reform law enacted after the financial crisis, we publicly report in detail on our lending programs and securities purchases, including the identities of borrowers and counterparties, amounts lent or purchased, and other information, such as collateral accepted. In late 2010, we posted detailed information on our public website about more than 21,000 individual credit and other transactions conducted to stabilize markets during the financial crisis. And, just last Friday, we posted the first in an ongoing series of quarterly reports providing a great deal of information on individual discount window loans and securities transactions. The Federal Reserve's financial statement is audited by an independent, outside accounting firm, and an independent Inspector General has wide powers to review actions taken by the Board. Importantly, the Government Accountability Office (GAO) has the ability to--and does--oversee the efficiency and integrity of all of our operations, including our financial controls and governance.

While the GAO has access to all aspects of the Fed's operations and is free to criticize or make recommendations, there is one important exception: monetary policymaking. In the 1970s, the Congress deliberately excluded monetary policy deliberations, decisions, and actions from the scope of GAO reviews. In doing so, the Congress carefully balanced the need for democratic accountability with the benefits that flow from keeping monetary policy free from short-term political pressures.

However, there have been recent proposals to expand the authority of the GAO over the Federal Reserve to include reviews of monetary policy decisions. Because the GAO is the investigative arm of the Congress and GAO reviews may be initiated at the request of members of the Congress, these reviews (or the prospect of reviews) of individual policy decisions could be seen, with good reason, as efforts to bring political pressure to bear on monetary policymakers. A perceived politicization of monetary policy would reduce public confidence in the ability of the Federal Reserve to make its policy decisions based strictly on what is good for the economy in the longer term. Balancing the need for accountability against the goal of insulating monetary policy from short-term political pressure is very important, and I believe that the Congress had it right in the 1970s when it explicitly chose to protect monetary policy decision making from the possibility of politically motivated reviews.

Conclusion In conclusion, I will simply note that these past few years have been a difficult time for the nation and the economy. For its part, the Federal Reserve has also been tested by unprecedented challenges. As we approach next year's 100th anniversary of the signing of the Federal Reserve Act, however, I have great confidence in the institution. In particular, I would like to recognize the skill, professionalism, and dedication of the employees of the Federal Reserve System. They work tirelessly to serve the public interest and to promote prosperity for people and businesses across America. The Fed's policy choices can always be debated, but the quality and commitment of the Federal Reserve as a public institution is second to none, and I am proud to lead it.

Now that I've answered questions that I've posed to myself, I'd be happy to respond to yours.

1. The Fed has a number of ways to influence short-term rates; basically, they involve steps to affect the supply, and thus the cost, of short-term funding.

The stone money of Yap is an interesting case to consider when thinking about what money is and what role it plays in the economic and social affairs of a community. This article by Michael Bryan of the Federal Reserve Bank of Cleveland describes the stone wheels of Yap, how they were obtained and used as gift markers both within and between tribes, and whether the stones fit the textbook definition of money:

Federal Reserve Bank of Cleveland, Island Money, by Michael F. Bryan: ...In this Commentary, I … consider… the unique and curious money of Yap, a small group of islands in the South Pacific. … For at least a few centuries leading up to today, the Yapese have used giant stone wheels called rai when executing certain exchanges. The stones are made from a shimmering limestone that is not indigenous to Yap, but quarried and shipped, primarily from the islands of Palau, 250 miles to the southwest. The size of the stones varies; some are as small as a few inches in diameter and weigh a couple of pounds, while others may reach a diameter of 12 feet and weigh thousands of pounds. A hole is carved into the middle of each stone so that it may be carried, either by coconut rope strung through the smaller pieces, or by wooden poles inserted into the larger stones. These great stones require the combined effort of many men to lift. Expeditions to acquire new stones were authorized by a chief who would retain all of the larger stones and two-fifths of the smaller ones, reportedly a fairly common distribution of production that served as a tax on the Yapese. In effect, the Yap chiefs acted as the island’s central bankers; they controlled the quantity of stones in circulation...

The quarrying and transport of rai was a substantial part of the Yapese economy. In 1882, British naturalist Jan S. Kubary reported seeing 400 Yapese men producing stones on the island of Palau for transport back to Yap. Given the population of the island at the time … more than 10 percent of the island’s adult male population was in the money-cutting business. Curiously, rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money. Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established...

Precisely how the value of each stone was determined is somewhat unclear. We know that size was at best only a rough approximation of worth and that stone values varied depending upon the cost or difficulty of bringing them to the island. For example, stones gotten at great peril, perhaps even loss of life, are valued most highly. Similarly, stones that were cut using shell tools and carried by canoes are more valuable than comparably sized stones that were quarried with the aid of iron tools and transported by large Western ships. The more valuable stones were given names, such as that of the chief for whom the stone was quarried or the canoe on which it was transported. Naming the stone may have secured its value since such identification would convey to all the costs associated with obtaining it...

Consider the case of the Irish American David O’Keefe from Savannah, Georgia, who, after being shipwrecked on Yap in the late nineteenth century, returned to the island with a sailing vessel and proceeded to import a large number of stones in return for a bounty of Yapese copra (coconut meat). The arrival of O’Keefe (and other Western traders) increased the number and size of the stones being brought back to the island, and by one accounting, Yap stones went from being “very rare” in 1840 to being plentiful—more than 13,000 were to be found on the island by 1929. No longer restricted by shell tools and canoes, the largest stones arriving grew from four feet in diameter to the colossal 12-foot stones that are now a part of monetary folklore. Yet the great infusion of stones did not inflate away their value. Since the stones of Captain O’Keefe were obviously more easily obtained, they traded on the island at an appropriately reduced value relative to the older stones gotten at much greater cost. In essence, O’Keefe and other Westerners were bringing in large numbers of “debased” stones that could easily be identified by the Yapese.

While it’s clear that the Yap stones have value for the Yapese, can the stones really be called money? The answer, of course, depends upon how you define money. If you rely on a standard textbook definition, you’d describe money in terms of its functions, for example, “Whatever is used as a medium of exchange, unit of account, and store of value.” Certainly, Yap stones performed at least one of these functions quite well—they were an effective store of value (form of wealth). But every asset—from bonds to houses—stores value and is not necessarily labeled money.

To be called money, at least according to the textbook definition, an asset must serve two other functions. It must be a medium of exchange, meaning that it can be readily used either to purchase goods or to satisfy a debt, and it must be a unit of account, or something used as a measure of value. Yap stones were not the unit of account for the islands. Pricing goods and services in terms of the stones would probably have been difficult for the average islander. ... According to Paul Einzig, prices on the islands were set in terms of baskets of a food crop, taro, or cups of syrup, staples that would be easy for a typical islander to appreciate. Furthermore, there is some question whether Yap stones were commonly used as a medium of exchange. To be used in exchange, an item must possess certain characteristics—it must be storable, portable, recognizable, and divisible. Certainly, the stones were storable; they can still be found in abundance on Yap, and they have maintained their purchasing power reasonably well over time (particularly compared with other fiat monies, including dollars). And while it is sometimes claimed that Yap stones suffer as an exchange medium because they lack portability, this may not be completely accurate. In the case of the larger, more easily identified stones, physical possession is not necessary for the transfer of purchasing power. Those involved in the exchange need only communicate that purchasing power has been transferred…

But while storability and portability may not have limited the use of these stones as a medium of exchange, the other two characteristics—recognizability and divisibility—probably did. The stones were primarily used in exchanges between Yap islanders. … Yap historically did not have close cultural ties with any of its trading partners and trade with off-islanders was somewhat infrequent, the stones did not facilitate transactions on these occasions. When transacting with other islands, the Yapese used woven mats (a common exchange medium throughout the South Pacific), while trade with Westerners often involved an exchange of coconuts. Even on the island, the indivisibility of the stones necessitated the use of other items as media of exchange for most transactions. Most rai are highly valued: By one account, a stone of “three spans” (about 25 inches across) would have been sufficient in the early twentieth century to purchase 50 baskets of food or a full-sized pig, while a stone the size of a man would have been worth “many villages and plantations.” Obviously, these stones do not change hands very frequently, since expenditures of such magnitude are rare. For more ordinary transactions, the Yapese either used pearl shells or resorted to barter. Clearly the stones of Yap do not fit neatly within the textbook definition of money…

But … what role do the stones play and how is that role similar to that played by dollars?... [T]he stones, particularly the larger ones, acted as markers, changing hands in recognition of a “gift.” Stones were often merely held until the gift was reciprocated and the stone could be returned to its original owner. For example, islanders wishing to fish someone’s waters might do so by leaving a stone in recognition of the favor. After an appropriate number of fish were given to the owner of the fishing waters, the stone would simply be reclaimed. Occasionally a stone was “exchanged” when one tribe came to the aid of another, say for support against a rival tribe or in celebration of some event. But the stone would reside with the new tribe only until such time as aid of a similar value could be given in return. The stones, then, act as a memory of the contributions occurring between islanders. Anthropologists refer to this as a “gift economy,” where goods aren’t traded as much as they are given with the expectation of a comparable favor at some later date. So Yap stones serve as a memory of one’s contributions on the island. … But this raises an intriguing question. If the stones of Yap were merely markers and nothing more, why did the Yapese expend such great resources to carve them out of the mountains of Palau and carry them all the way back to their island? Wouldn’t any marker work just as well? It may be that the Yap chiefs did not have sufficient “credibility” to simply decree an object’s value. That is, the Yapese may have needed some assurance that the object on which value has been assigned could not be easily replicated for the mere benefit of the issuer...

Before independence, America's disparate colonial economies struggled with a very material financial hang-up: there just wasn't enough money to go around. Colonial governments attempted to solve this problem by using tobacco, nails, and animal pelts for currency, assigning them a set amount of shillings or pennies so that they could intermix with the existing system.

The most successful ad hoc currency was wampum, a particular kind of bead made from the shells of ocean critters. But eventually the value of this currency, like that of other alternative currencies of the day, was undermined by oversupply and counterfeiting. (That's right: counterfeit wampum. They were produced by dyeing like-shaped shells with berry juice, mimicking the purple color of the real thing.)

It was a crew of Puritans from Boston who first put their faith in paper. Initially, the Massachusetts Bay Colony tried to issue colonial coinage. The pieces themselves, struck in 1652, were made from a mash-up of poor-quality silver and were soon outlawed by the Brits. Less than a decade later the colonists tried again. They were forced to, really, because they owed money to the crown to help fund Britain's war against France, yet lacked any currency with which to pay up. They called the paper "bills of credit." The local government essentially said to the people: Here, just use this. It's real money. We'll sort out redeemability later.

There were endless debates, from prairie farmlands to the floor of Congress, about whether this paper was real money or just a smoke-and-mirrors scheme destined to end badly. ...[continue]...

So far, no clear sign that wage growth is accelerating. Even more important, however, wages are growing much more slowly now than they were before the crisis. There is no argument I can think of for not wanting wage growth to get at least back to pre-crisis levels before tightening. In fact, given that we’ve now seen just how dangerous the “lowflation” trap is, we should be aiming for a significantly higher underlying rate of growth in wages and prices than we previously thought appropriate.

I don't think that you should be surprised if the Federal Reserve starts raising rates well before wage growth returns to pre-crisis rates. I think you should be very surprised if the Fed were to do as Krugman suggests. Historically, the Fed tightens before wages growth accelerates much beyond 2%:

As I have noted earlier, wage growth tends to accelerate as unemployment approaches 6 percent, and so if you wanted to be ahead of inflation, they would be thinking about the first rate hike in the 6.0-6.5% range. That 6.5% threshold was not pulled out of thin air.

The second point is that the tightening cycle is usually topping out when wage growth is in the 4.0-4.5% range. One interpretation is that the Fed continues to tighten policy to prevent workers from gaining too much of an upper-hand, thereby contributing to growing wage inequality. Of course, I doubt they see it that way. They see it as tightening monetary conditions to hold inflation in check. Either way, the end is the same. It would represent a very significant departure from past policy if the Fed waited until wage growth was at pre-recession rates before they tightened policy or if they allow conditions to remains sufficiently loose for wage growth to eventually rise above pre-recession rates.

If you want the Fed to make such a departure, start laying the groundwork soon. The best I can offer is my expectation that Fed Chair Janet Yellen is more inclined than the average policymaker to wait until wages actually rise before acting. I have trouble believing that even she would wait until wage growth accelerates to pre-recession trends.

But a funny thing happens once unemployment hits 6.5 percent: The behavior of inflation starts to become random, as illustrated in this chart by HSBC chief U.S. economist Kevin Logan.

The black line represents the average annual unemployment rate for the past 30 years. You can see that in all but two cases (both of which were temporary shocks), inflation declined when the jobless rate was above 6.5 percent. But when unemployment rate fell below that point, inflation was almost as likely to increase as it was to decrease. In other words, what happens to inflation below the Fed’s threshold is anybody’s guess.

I would take issue with the idea that inflation behavior becomes "random" at unemployment rates below 6.5%. You need to consider this kind of chart in the context of expected inflation and expected policy. If inflation expectations are stable, and if the Federal Reserve provides policy to ensure that stability, you would expect random errors around expected inflation. Couple this with downward nominal wage rigidities, and you should expect the same even under circumstances of high unemployment. Here is my version of the same chart:

The data is monthly. This y-axis is the change in inflation from a year ago, where inflation is measured as the year-over-year change in core-pce. Unsurprisingly, since 2000, changes in core-inflation vary around zero. Stable and low inflation expectations. During periods of the 1970's and 1980's you see the impact of unstable expectations as the relationship circles all over the place. But you also see the general pattern of disinflation since the early 1980's with the downward sloping relationship and many inflation observations, even at low unemployment rates, below zero.

Now it is fairly easy to put both of these posts together. The Fed, wanting to ensure stable inflation expectations, begins raising interest rates well before wage rates begin rising. This is turn controls the growth of actual inflation so that inflation rates do not rise as unemployment falls further. The deviations of inflation from expectations are then just noise. But actual inflation is not "random." It is the result of specific monetary policy.

Bottom Line: If the Fed follows historical behavior, they will begin tightening before wages rise and in an environment of low inflation such that inflation remains stable even as unemployment falls. In other words, in recent history that have not exhibited a tendency to overshoot. Explicit overshooting would represent a very significant shift in the Fed's modus operandi.

With the end of asset purchases in sight (and assuming activity does not lurch downward) Fed officials will increasingly turn the discussion toward raising interest rates. It is not as if the anticipated time line has been any secret. The Fed's forecasts clearly show an expectation of higher rates in 2015 with the exact timing and pace of that tightening dependent upon each participant's growth and inflation forecast. Fed officials would want to clearly telegraph such a move well in advance. Hence they will pivot from talk of sustained low rates to raising rates. Of course, we would expect hawks to be first in line, as they have been. For instance, Philadelphia Federal Reserve President said last week (via the Wall Street Journal):

“Most formulations of standard, simple policy rules suggest that the federal funds rate should rise very soon–if not already,” Mr. Plosser told a conference sponsored by the University of Chicago‘s Booth School of Business.

Such warnings from Plosser are not new. More notable is San Fransisco Federal Reserve President John Williams' interview with Robin Harding at the Financial Times. Williams is generally seen as a dove, but he was also was one of the first to telegraph the end of asset purchases. Williams on the forecast:

In his own economic forecast, Mr Williams said, the Fed will raise interest rates in the middle of next year with the unemployment rate at about 6 per cent, inflation at 1.5 per cent and “everything moving in the right direction”.

“At that point if we don’t start to adjust monetary policy there’d be a risk of overshooting,” he said. “You don’t wait until you’re at full employment before you start to raise interest rates from zero.”

There is a lot to think about in those two paragraphs. First is a forecast of 6% unemployment 15 months or so from now. Given the rapid drop in the unemployment rate, it is completely believable that we reach 6% before asset purchases are predicted to end later this year. Given Williams' forecast, this suggests to me that the risk here is a more rapid tapering or earlier rate hike. The second is the idea of raising rates when inflation is only 1.5%. This to me suggests that Williams is expecting to reach the 2% target from below, not above. This seems clear from the next point: Williams wants to take the possibility of overshooting off the table.

Note that Williams' position differs greatly from that of Chicago Federal Reserve President Charles Evans. From a speech last week:

A slow glide toward our goals from large imbalances risks being stymied along the way and is more likely to fail if adverse shocks hit beforehand. The surest and quickest way to get to the objective is to be willing to overshoot in a manageable fashion. With regard to our inflation objective, we need to repeatedly state clearly that our 2 percent objective is not a ceiling for inflation. Our “balanced approach” to reducing imbalances clearly indicates our symmetric attitudes toward our 2 percent inflation objective.

Evans is obviously willing to overshoot, where Williams is not. Whether the consensus sides with Williams or Evans is critical to the timing of the first rate hike. If the consensus is set on hitting the inflation target from below, then we have have to consider the Fed's own forecasts as suspect. They will find themselves moving sooner than they expect.

I would say, however, it is widely believed, on the basis of her "optimal control" analysis, that Federal Reserve Chair Janet Yellen leans toward Evans. Any suggestion that Yellen leans toward Williams on the overshooting question would be notable.

Mr Williams said it would take a “substantial change in the outlook” before he was willing to revisit the Fed’s plan to slow purchases by $10bn at each meeting, and despite some weak data, that has not yet happened. “We haven’t really changed our basic outlook for the economy.”...

...Mr Williams said that as long as average monthly jobs growth stays well above 100,000 then unemployment will continue to come down. “What would worry you is if you don’t have an explanation for why it’s weaker and you get multiple months below that,” he said.

I don't think this should come as a surprise. The Fed has been looking to get out of the asset purchase business since the beginning of 2013. The end is now in sight, and only the most disconcerting of data will change that. They may say they are data dependent (Williams of course adds that he could envision circumstances in which the Fed slow or even reverse tapering), but the reality is they have a bias against asset purchases.

The desire to exit asset purchases only increases as the unemployment rate falls. I think that Joe Weisenthal is on the money here when he points out that economists are gravitating toward the idea the the changes in the labor market are largely structural. In other words, as St. Louis Federal Reserve puts it (via the Wall Street Journal):

“I think that unemployment is really sending the right signal about the labor market” and the decline in the labor force participation rate is largely a demographic issue that will play out over a long time horizon, he said.

I think that Fed officials have long seen the risk that this might be true, which is one factor that biases them against asset purchases. Increasing, though, I suspect they do not see is as a risk, but as reality. Again, the consequence is that rates might be rising sooner than Fed officials currently anticipate. It is worth repeating this chart:

In the past, wage growth accelerates as unemployment hits 6%. With unemployment well above 6%, it was difficult to conclusively say much one way or another about the exact amount of slack in the labor market as there was certainly enough slack to keep wage growth in check. If the unemployment rate is no longer the appropriate indicator of labor market slack, then we should not expect to see upward wage pressure as 6% looms. If that pressure does emerge, then I think we learn something about the amount of slack. From the Fed's point of view, if they see wage growth, they will suspect their isn't much. Wage growth will raise concerns about unit labor costs, which will in turn raise concerns about inflation.

Weisenthal, however, adds:

The view from the left is basically: Even if the labor market is getting tight (which they deny), the Fed should press hard on the gas pedal, so that employers start to employ the long-term unemployed.

And that might be the proper path, and if there's anyone who has the stomach to engage in the strategy, it's probably Janet Yellen.

Once again, this implies that Yellen is willing to risk overshooting. Her views on overshooting are critical to the evolution of policy at this point.

Bottom Line: Put aside the possibility of an international crisis-fueled collapse in activity. The Fed's baseline view is that economic growth continues this year at a pace sufficient to end the asset purchase program. The Fed will resist changing that plan for any minor stumble in activity. The pace of job creation itself might not be that critical; it simply needs to be fast enough to lower unemployment to justify continuing the taper. Moreover, we are reaching a point where the Fed will need to decide to what extent it will risk overshooting. That was never really a risk of overshooting above 6% unemployment. Soon it will be an interesting question. The timing of the first rate hike and the subsequent tightening is dependent upon the consensus on overshooting. If wage growth starts to accelerate, the Fed's focus will shift from fears of too much to too little slack. If they are concerned about overshooting, they will need to accelerate the tightening time line. Where Yellen ultimately falls on the issue is critical.

Bitcoin has been focused on the wrong classical functions of money, as a medium of exchange and a store of value. ... It would be much better to focus on another classical function: money as a unit of account...

This has already begun to happen. ... For example, since 1967 in Chile, an inflation-indexed unit of account called the unidad de fomento (U.F.), meaning unit of development, has been widely used. Financial exchanges are made in pesos, according to a U.F.-peso rate posted on the website valoruf.cl. One multiplies the U.F. price by the exchange rate to arrive at the amount owed today in pesos. In this way, it is natural and easy to set inflation-indexed prices, and Chile is much more effectively inflation-indexed than other countries are. ...

With electronic software in the background, we can ... move beyond just one new unit of account to a whole system of them...

Bitcoin has been a bubble. But the legacy of the Bitcoin experience should be that we move toward a system of stable economic units of measurement — a system empowered by sophisticated mechanisms of electronic payment.

The next two charts show contributions to changes in debt balances by borrower age, first when household credit was expanding rapidly in 2006, and then in 2013. For each age group, the charts show the percentage change in aggregate debt outstanding for each type. Thus, summing the numbers for a given loan type produces the overall percentage growth for that type over the relevant four-quarter period.

A couple of things stand out. First, overall growth in debt remains considerably more muted in 2013 than it was in 2006, with the exception of auto loans, where 2013 data continued to reflect the strong growth we have been seeing since mid-2011, and student loans. (In the case of student loans, the percentage growth has moderated since 2006, but since the outstanding balance has doubled, the lower percentage growth is associated with comparable dollar increases.) Mortgage and home equity line of credit (HELOC) balances, in particular, grew much more slowly in 2013 than in 2006. Second, for all loan types and in both years, balance increases were mainly driven by younger age groups. Again, though, student loans are an exception: even older student loan borrowers continue to increase their borrowing.

The next two charts break down the same data, this time by Equifax risk score (or credit score) groups.

On the credit score breakdown we see stark differences in patterns for mortgages and HELOCs between the 2013 and 2006 cohorts. Notably, in 2013, balances fell for the lowest credit score borrowers—the result of charge-offs from previous foreclosures—while all groups, even those with subprime credit scores, increased their mortgage balances in 2006. Now, the modest mortgage balance increases we see are mainly coming from high credit score borrowers.

A similar picture emerges for credit card balances. Note, though, that credit card balances for subprime borrowers were falling in 2006, again mostly due to charge-offs, making the increased mortgage balance for that group in 2006 seem all the more remarkable.

There’s been a tremendous amount of attention to the growth of student loans in recent years, and these charts indicate some of the reason why. First, student loans grew the most of any debt product in both periods (in percentage terms). Second, the growth in educational debt, like that of auto loans, is concentrated among the lower and middle credit score groups.

But auto and student loans have been growing for some time, while overall debt continued to fall. In 2013, the increased credit card and mortgage debt among the young and the riskless led to a turnaround in the trajectory of overall debt.

For a more detailed look at net borrowing by age and credit score in 2006 and 2013, please take a look at our interactive graphic.

Disclaimer The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Crisis Chronicles: The Commercial Credit Crisis of 1763 and Today’s Tri-Party Repo Market, by James Narron and David Skeie, Liberty Street Economics Blog, FRBNY: During the economic boom and credit expansion that followed the Seven Years’ War (1756-63), Berlin was the equivalent of an emerging market, Amsterdam’s merchant bankers were the primary sources of credit, and the Hamburg banking houses served as intermediaries between the two. But some Amsterdam merchant bankers were leveraged far beyond their capacity. When a speculative grain deal went bad, the banks discovered that there were limits to how much risk could be effectively hedged. In this issue of Crisis Chronicles, we review how “fire sales” drove systemic risk in funding markets some 250 years ago and explain why this could still happen in today’s tri-party repo market.

Early Credit Wrappers One of the primary financial credit instruments of the 1760s was the bill of exchange—essentially a written order to pay a fixed sum of money at a future date. Early forms of bills of exchange date back to eighth-century China; the instrument was later adopted by Arab merchants to facilitate trade, and then spread throughout Europe. Bills of exchange were originally designed as short-term contracts but gradually became heavily used for long-term borrowing. They were typically rolled over and became de facto short-term loans to finance longer-term projects, creating a classic balance sheet maturity mismatch. At that time, bills of exchange could be re-sold, with each seller serving as a signatory to the bill and, by implication, insuring the buyer of the bill against default. This practice prevented the circulation of low-credit-quality bills among market participants and created a kind of “credit wrapper”—a guarantee for the specific loan—by making all signatories jointly liable for a particular bill. In addition, low acceptance fees—the fees paid to market participants for taking on the obligation to pay the bill of exchange—implied a perceived negligible risk. But the practice also resulted in binding market participants together through their balance sheets: one bank might have a receivable asset and a payable liability for the same bill of exchange, even when no goods were traded. By the end of the Seven Years’ War in 1763, high leverage and balance sheet interconnectedness left merchant bankers highly vulnerable to any slowdown in credit availability.

Tight Credit Markets Lead to Distressed Sales Merchant bankers believed that their balance sheet growth and leverage were hedged through offsetting claims and liabilities. And while some of the more conservative Dutch bankers were cautious in growing their wartime business, others expanded quickly. One of the faster growing merchant banks belonged to the de Neufville brothers, who speculated in depreciating currencies and endorsed a large number of bills of exchange. Noting their success (if only in the short term), other merchant bankers followed suit. The crisis was triggered when the brothers entered into a speculative deal to buy grain from the Russian army as it left Poland. But with the war’s end, previously elevated grain prices collapsed by more than 75 percent, and the price decline began to depress other prices. As asset prices fell, it became increasingly difficult to get new loans to roll over existing debt. Tight credit markets led to distressed sales and further price declines. As credit markets dried up, merchant bankers began to suffer direct losses when their counterparties went bankrupt.

The crisis came to a head in Amsterdam in late July 1763 when the banking houses of Aron Joseph & Co and de Neufville failed, despite a collective action to save them. Their failure caused the de Neufville house’s creditors around Amsterdam to default. Two weeks later, Hamburg saw a wave of bank collapses, which in turn led to a new wave of failures in Amsterdam and pressure in Berlin. In all, there were more than 100 bank failures, mostly in Hamburg.

An Early Crisis-Driven Bailout The commercial crisis in Berlin was severe, with the manufacturer, merchant, and banker Johann Ernst Gotzkowsky at the center. Gotzkowsky’s liabilities were almost all in bills of exchange, while almost all his assets were in fixed capital divided among his silk works and porcelain factory. Berlin was able to mitigate the effects of the crisis when Crown Prince Frederick imposed a payments standstill for several firms. To prevent contagion, the prince also organized some of the first financial-crisis-driven bailouts after he examined the books of Gotzkowsky’s diverse operations. Ultimately, about half of Gotzkowsky’s creditors accepted 50 cents on the dollar for outstanding debts.

Meanwhile, banks in Hamburg and the Exchange Bank of Amsterdam tried to extend securitized loans to deflect the crisis. But existing lending provisions restricted the ratio of bank money to gold and silver such that the banks had no real power to expand credit. These healthy banks were legally limited in their ability to support the credit-constrained banks. To preserve cash on hand, Hamburg and Amsterdam banks were slow to honor bills of exchange, eventually honoring them only after pressure from Berlin. The fact that Amsterdam and Hamburg banks re-opened within the year—and some even within weeks—provides evidence that the crisis was one of liquidity and not fundamental insolvency.

The crisis led to a period of falling industrial production and credit stagnation in northern Europe, with the recession being both deep and long-lasting in Prussia. These developments prompted a second wave of bankruptcies in 1766.

Distressed Fire Sales and the Tri-Party Repo Market From this crisis we learn that it is difficult for firms to hedge losses when market risk and credit risk are highly correlated and aggregate risk remains. In this case, as asset prices fell during a time of distressed “fire sales,” asset prices became more correlated, further exacerbating downward price movement. When one firm moved to shore up its balance sheet by selling distressed assets, that put downward pressure on other, interconnected balance sheets. The liquidity risk was heightened further because most firms were highly leveraged. Those that had liquidity guarded it, creating a self-fulfilling flight to liquidity.

As we saw during the recent financial crisis, the tri-party repo market was overly reliant on massive extensions of intraday credit, driven by the timing between the daily unwind and renewal of repo transactions. Estimates suggest that by 2007, the repo market had grown to $10 trillion—the same order of magnitude as the total assets in the U.S. commercial banking sector—and intraday credit to any particular broker/dealer might approach $100 billion. And as in the commercial crisis of 1763, risk was underpriced with low repo “haircuts”—a haircut being a demand by a depositor for collateral valued higher than the value of the deposit.

Much of the work to address intraday credit risk in the repo market will be complete by year-end 2014, when intraday credit will have been reduced from 100 percent to about 10 percent. But as New York Fed President William C. Dudley noted in his recent introductory remarks at the conference “Fire Sales” as a Driver of Systemic Risk, “current reforms do not address the risk that a dealer’s loss of access to tri-party repo funding could precipitate destabilizing asset fire sales.” For example, in a time of market stress, when margin calls and mark-to-market losses constrain liquidity, firms are forced to deleverage. As recently pointed out by our New York Fed colleagues, deleveraging could impact other market participants and market sectors in current times, just as it did in 1763.

Crown Prince Frederick provided a short-term solution in 1763, but as we’ll see in upcoming posts, credit crises persisted. As we look toward a tri-party repo market structure that is more resilient to “destabilizing asset fire sales” and that prices risk more accurately, we ask, can industry provide the leadership needed to ensure that credit crises don’t persist? Or will regulators need to step in and play a firmer role to discipline dealers that borrow short-term from money market fund lenders and draw on the intraday credit provided by clearing banks? Tell us what you think.

DisclaimerThe views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Yellen's Debut as Chair, by Tim Duy: Janet Yellen made her first public comments as Federal Reserve Chair in a grueling, nearly day-long, testimony to the House Financial Services Committee. Her testimony made clear that we should expect a high degree of policy continuity. Indeed, she said so explicitly. The taper is still on, but so too is the expectation of near-zero interest rates into 2015. Data will need to get a lot more interesting in one direction or the other for the Fed to alter from its current path.

In here testimony, Yellen highlighted recent improvement in the economy, but then turned her attention to ongoing underemployment indicators:

Nevertheless, the recovery in the labor market is far from complete. The unemployment rate is still well above levels that Federal Open Market Committee (FOMC) participants estimate is consistent with maximum sustainable employment. Those out of a job for more than six months continue to make up an unusually large fraction of the unemployed, and the number of people who are working part time but would prefer a full-time job remains very high. These observations underscore the importance of considering more than the unemployment rate when evaluating the condition of the U.S. labor market.

A visual reminder of the issue:

This is a straightforward reminder of the Fed's view that the unemployment rate overstates improvement in labor markets and thus should be discounted when setting policy. Consequently, policymakers believe they have room to hold interest rates at rock bottom levels for an extended period. To be sure, there are challenges to this view, both internally and externally. For instance, Philadelphia Federal Reserve President Charles Plosser today reiterated his view that asset purchases should end soon and also fretted that the Fed will be behind the curve with respect to interest rates. Via Bloomberg:

“I’m worried that we’re going to be too late” to raise rates, Plosser told reporters after a speech at the University of Delaware in Newark. “I don’t want to chase the market, but we may have to end up having to do that” if investors act on anticipation of higher rates.

That remains a minority view at the Fed. Matthew Boesler at Business Insider points us at UBS economists Drew Matus and Kevin Cummins, who challenge Yellen's belief that the long-term unemployed will keep a lid on inflation:

We do not view the long-term unemployed as necessarily "ready for work" and therefore believe that their ability to restrain wage pressures is limited. In other words, the unusually high number of long-term unemployed suggests that the natural rate of unemployment has increased. Indeed, when we have tested various unemployment rates' ability to predict inflation we found that the standard unemployment rate outperforms all other broader measures reported by the Bureau of Labor Statistics. Although we disagree with Yellen regarding the long-term unemployed, our research does suggest that, perhaps unsurprisingly, the number of part-timers does have an impact on restraining inflation.

I tend to think that we will not see clarity on this issue until unemployment approaches even nearer to 6%. That level has traditionally been associated with rising wages pressures in the past:

The Fed would likely see a faster pace of wage gains as lending credence to the story that the drop in labor force participation is mostly a structural story. At that point the Fed may begin rethinking the expected path of interest rates, depending on their interest in overshooting. But in the absence of such early signs of inflationary pressures, the Fed will be content to raise rates only gradually.

With regards to monetary policy, Yellen reminds everyone that she helped design the current policy:

Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability.

Yellen makes clear that the current pace of tapering is likely to continue:

If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.

Later, during the question and answer period, Yellen does however, open the door for a pause in the taper. Via Pedro DaCosta and Victoria McGrane at the Wall Street Journal:

“I think what would cause the committee to consider a pause is a notable change in the outlook,” Ms. Yellen told lawmakers...

...“I was surprised that the jobs reports in December and January, the pace of job creation, was running under what I had anticipated. But we have to be very careful not to jump to conclusions in interpreting what those reports mean,” Ms. Yellen said. Recent bad weather may have been a drag on economic activity, she added, saying it would take some time to get a true sense of the underlying trend.

The January employment report was something of a mixed bag, with the unemployment rate edging down further to 6.6% while nonfarm payrolls disappointed again (!!!!) with a meager gain of 113k. That said, I still do not believe this should dramatically alter your perception of the underlying pace of activity. Variance in nonfarm payrolls is the norm, not the exception:

Her disappointment in the numbers raises the possibility - albeit not my central case - that another weak number in the February report could prompt a pause. My baseline case, however, is that even if it was weak, it would not effect the March outcome but instead, if repeated again, the outcome of the subsequent meeting. Remember, the Fed wants to end asset purchases. As long as they believe forward guidance is working, they will hesitate to pause the taper.

Yellen was not deterred by the recent turmoil in emerging markets:

We have been watching closely the recent volatility in global financial markets. Our sense is that at this stage these developments do not pose a substantial risk to the U.S. economic outlook. We will, of course, continue to monitor the situation.

Yellen reiterates the current Evans rule framework for forward guidance, giving no indication that the thresholds are likely to be changed. Jon Hilsenrath at the Wall Street Journal interprets this to mean that when the 6.5% unemployment rate threshold is breached, the Fed will simply switch to qualitative forward guidance. I tend to agree.

Bottom Line: Circumstances have not change sufficiently to prompt the Federal Reserve deviate from the current path of policy.

When Will the Fed End Its Zero Rate Policy?, by Jens Christensen, FRBSF Economic Letter: The severe shock of the 2007–08 financial crisis prompted the Federal Reserve to quickly lower its target for its primary policy rate, the overnight federal funds rate, near to zero, where it has remained since. Despite this highly stimulatory stance of conventional monetary policy, the economic recovery has been sluggish and inflation has been low. For that reason, the Federal Open Market Committee (FOMC), the Fed’s policy body, has provided additional monetary stimulus by using unconventional measures to push down longer-term interest rates. One element of this unconventional policy has been large-scale asset purchases (LSAPs). Another has been public guidance about how long the FOMC expects to keep its federal funds rate target exceptionally low. The effect of this forward guidance depends on how financial market participants interpret FOMC communications, in particular when they expect the Fed to exit from its near-zero rate policy, a shift often called “liftoff” (see Bauer and Rudebusch 2013).

This Economic Letter examines recent research estimating when bond investors expect liftoff to take place (see Christensen 2013). This research suggests that bond investor expectations for the date of exit have moved forward notably in recent months, probably because they anticipated the FOMC’s decision at its December 2013 meeting to cut back large-scale asset purchases. This research suggests that market participants expect the FOMC to start raising rates in the spring of 2015, but the exact timing is highly uncertain.

Unconventional monetary policy

Unconventional monetary policy designed to put downward pressure on longer-term interest rates has two aspects: large-scale asset purchases and forward guidance, that is, Fed communications about its expectations for future policy. LSAPs affect longer-term interest rates by shifting the term premium, the higher yield investors demand in exchange for holding a longer-duration debt security (see Gagnon et al. 2011). LSAPs were first announced in late 2008. The most recent program, initiated in September 2012, originally involved purchasing $40 billion in mortgage-backed securities (MBS) every month. It expanded in December 2012 to include $45 billion in monthly Treasury security purchases. The FOMC stated that it intended to continue the program until the outlook for the labor market improved substantially, provided inflation remained stable. Since then, the labor market has improved and the unemployment rate has dropped. As a result, the FOMC decided at its December 2013 meeting to reduce the pace at which it adds to its asset holdings to $75 billion per month.

Forward guidance affects longer-term rates by influencing market expectations about the level of short-term interest rates over an extended period. In August 2011, the FOMC stated that it intended to keep its federal funds rate target near zero until mid-2013, the first time it projected a liftoff date. More recently, Fed policymakers have indicated that they anticipate keeping the federal funds rate at that exceptionally low level at least as long as the unemployment rate remains above 6½%, inflation one to two years ahead is projected to be no more than one-half percentage point above the FOMC’s 2% longer-run target, and longer-term inflation expectations remain in check. In December 2013, the FOMC added that, based on current projections, it expects to maintain the zero interest rate policy well past when the unemployment rate falls below 6½%.

Figure 1 FOMC member projections of appropriate policy rate

FOMC projections versus Treasury market data

Forward guidance also includes a set of projections on future federal funds rate levels that each FOMC participant makes four times per year, released in conjunction with the FOMC statement. Based on their views of appropriate monetary policy, these policymakers also forecast overall inflation; core inflation, which excludes volatile food and energy prices; the unemployment rate; and output growth. Figure 1 shows FOMC median, 25th percentile, and 75th percentile federal funds rate projections made in September and December. Only minor changes occurred from September to December.

Figure 2 Treasury yield curves on three dates in 2013

The relatively stable FOMC projections stand in contrast to changes in the U.S. Treasury bond market over the same period. Figure 2 shows the Treasury yield curve, that is, yields on the full range of Treasury maturities, on the days of the September and December 2013 FOMC meetings as well as the December 27 reading. (The research is based on weekly Treasury yields recorded on Fridays. December 27 was the last Friday in 2013.) Medium- and longer-term Treasury yields increased notably during that period.

Other analysis suggests that much of this increase in longer-term Treasuries reflected an increase in the term premium. But did the rise in longer-term rates also involve a shift in the market’s views about expected short-term rates that seems out-of-step with FOMC guidance? To address this question, I use an innovative model of the Treasury yield curve developed in Christensen (2013) that delivers a distribution of estimates derived from Treasury security prices for the exit from the zero interest rate policy.

A model of the Treasury yield curve

In this model, it is assumed that the economy can be in one of two states: a normal state like that which prevailed before December 2008, and a state like the current one in which the monetary policy rate is stuck at its lower bound near zero. In the normal state, yield curve variation is captured by three factors that are not directly observable, but can be derived from the underlying data: the general level of rates; the slope of the yield curve; and the curvature, or shape, of the yield curve. Furthermore, it is assumed that, in the normal state, investors consider the possibility of the policy rate reaching zero to be negligible. This assumption implies that the transition to the zero-bound state that occurred in December 2008 was a surprise and did not affect bond prices before that, when the economy was in the normal state.

The zero-bound state is characterized by two key features. First, the shortest rate in the Treasury bond market is assumed to be constant at zero. Second, the state is viewed by bond investors and monetary policy makers as undesirable and temporary. They believe that the FOMC would like to return to normal as quickly as possible, consistent with the Fed’s price stability and maximum employment mandates. This implies that news about the U.S. economy prompts bond investors to revise their views about when the FOMC is likely to exit from its zero interest rate policy. In the model, that exit defines the transition from the zero-bound state to the normal state of the economy. One component of the variation of Treasury bond yields in the zero-bound state is how probable bond investors believe a return to the normal state to be. However, because bond investors are forward looking and consider the possibility of such a shift when they trade, the three factors that affect the yield curve in the normal state continue to affect it in the zero-bound state.

Figure 3 Intensity of exit time from the zero interest rate policy

Results

To derive estimates of the date of the FOMC’s first federal funds rate increase, I use weekly Treasury yields starting in January 1985 of eight maturities ranging from three months to ten years. The novel feature of the model I use is consideration of the implicit probability bond investors attach to a transition back to the normal state. This allows the entire distribution of probable dates of exit from the zero-bound state to be examined. Figure 3 shows the likelihood of leaving the zero-bound state at any point in time as of December 27, 2013. The exit date distribution is heavily skewed so that very late exit times are significantly probable. Still, the median exit date is in March 2015. In other words, the economy is just as likely to remain in the zero-bound state at that date as to have exited before it. One takeaway is the considerable level of uncertainty about the exit date. The model suggests that there is about a one-in-three chance of remaining in the zero-bound state past 2015.

Figure 4 Median exit time from the zero interest rate policy

Figure 4 shows the variation in the estimated median exit time since December 16, 2008, when the economy shifted to the zero-bound state. Included are five dates from 2009 to 2012 of major FOMC announcements regarding LSAPs or guidance about future monetary policy. The estimated median exit time from the zero-bound state moved notably later in the weeks after each announcement, except when the FOMC extended its forward guidance in January 2012. This suggests that unconventional policies derive part of their effect by sending signals that bond market participants interpret to mean that the federal funds rate will remain at its zero bound longer than previously expected (see Christensen and Rudebusch 2012).

Consistent with these observations, Figure 4 also shows that the estimated median exit date from the near-zero federal funds rate moved forward significantly between the September and December 2013 FOMC meetings as market participants began anticipating the Fed’s decision to scale back LSAPs. According to the model, in anticipating the decision to trim LSAPs, the market also thought the first federal funds rate hike might come sooner than previously anticipated. This latter change in expectations held even though the FOMC’s projections of the appropriate future fed funds rate hardly changed from September to December. As of December 27, 2013, the median exit time for the market was estimated at one year and three months, which implies that the odds of keeping the near-zero interest rate policy past March 2015 are identical to the odds of exiting before that date.

Conclusion

A novel model of the Treasury yield curve allows an assessment of investor expectations of the exit date from the Fed’s near-zero interest rate policy. The results suggest that, as of the end of 2013, the expected exit date has moved forward notably since September 2013 despite only minor changes between September and December in FOMC participants’ projections of appropriate future monetary policy. However, the estimated distribution of the probable exit date is skewed so that the likelihood of an earlier or later exit is sizable. This finding is consistent with the inherent uncertainty about the outlook for inflation and unemployment, the economic variables that guide FOMC rate decisions.

[Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.]

Milton Friedman's "plucking model" is an interesting alternative to the natural rate of output view of the world. The typical view of business cycles is one where the economy varies around a trend value (the trend can vary over time also). Milton Friedman has a different story. In Friedman's model, output moves along a ceiling value, the full employment value, and is occasionally plucked downward through a negative demand shock. Quoting from the article below:

In 1964, Milton Friedman first suggested his “plucking model” (reprinted in 1969; revisited in 1993) as an asymmetric alternative to the self-generating, symmetric cyclical process often used to explain contractions and subsequent revivals. Friedman describes the plucking model of output as a string attached to a tilted, irregular board. When the string follows along the board it is at the ceiling of maximum feasible output, but the string is occasionally plucked down by a cyclical contraction.

Friedman found evidence for the Plucking Model of aggregate fluctuations in a 1993 paper in Economic Inquiry. One reason I've always liked this paper is that Friedman first wrote it in 1964. He then waited for almost twenty years for new data to arrive and retested his model using only the new data. In macroeconomics, we often encounter a problem in testing theoretical models. We know what the data look like and what facts need to be explained by our models. Is it sensible to build a model to fit the data and then use that data to test it to see if it fits? Of course the model will fit the data, it was built to do so. Friedman avoided that problem since he had no way of knowing if the next twenty years of data would fit the model or not. It did. I was at an SF Fed Conference when he gave the 1993 paper and it was a fun and convincing presentation.

Let me try, within my limited artistic ability, to illustrate further. If you haven't seen a plucking model, here's a graph to illustrate (see Piger and Morley and Kim and Nelson for evidence supporting the plucking model and figures illustrating the plucking and natural rate characterizations of the data). The "plucks" are the deviations of the red line from blue line representing the ceiling/trend:

Notice that the size of the downturn from the ceiling from a→b (due to the "pluck") is predictive of the size of the upturn from b→c that follows taking account of the slope of the trend. I didn't show it, but in this model the size of the boom, the movement from b→c, does not predict the size of the subsequent contraction. This is the evidence that Friedman originally used to support the plucking model. In a natural rate model, there is no reason to expect such a correlation. Here's an example natural rate model:

Here, the size of the downturn a→b does not predict the size of the subsequent boom b→c. Friedman found the size of a→b predicts b→c supporting the plucking model over the natural rate model.

Q&A: A Voice for an Activist Fed, NY Times: The Federal Reserve is often described as if it were a person – just one person – but it actually makes decisions by committee, and that committee is in flux. Only six of the 12 officials who voted on policy last January will still be voting when the Federal Open Market Committee holds its first meeting of 2014 this week.

Two new voters are likely to define the extremes of the debate as the committee charts the Fed’s continuing effort to revive the economy.

One is Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, perhaps the last official who wants the Fed to expand its efforts to reduce unemployment. Meanwhile, Richard Fisher, president of the Federal Reserve Bank of Dallas, is pressing for a faster retreat.

Mr. Kocherlakota and Mr. Fisher sat for separate interviews with The New York Times to talk about monetary policy and the economy this month before the media blackout that precedes each Fed meeting.

A transcript of Mr. Kocherlakota’s comments, edited for clarity, follows. [Mr. Fisher’s interview is in a separate post.]

The problem of stigma has been a lingering issue throughout the history of the DW. Prior to 2003, banks in distress could borrow from the DW at a rate below the fed funds target rate. Because of the subsidized rate, the Fed was concerned about “opportunistic overborrowing” by banks. Accordingly, before accessing the DW, a bank had to satisfy the Fed that it had exhausted private sources of funding and that it had a genuine business need for the funds. Hence, if market participants learned that a bank had accessed the DW, then they could reasonably conclude that the bank had limited sources of funding. The old DW regime therefore created a legitimate perception of stigma.

To address such stigma concerns, the Fed fundamentally changed its DW policy in 2003. In Regulation A, as revised in 2003, the Fed classified DW loans into primary credit, secondary credit, and seasonal credit. Financially strong and well-capitalized banks can borrow under the primary credit program at a penalty rate above the target fed funds rate (rather than a subsidized rate, as in the past). Other banks can use the secondary credit program and pay a rate higher than the primary credit rate. Finally, seasonal credit is for relatively small banks with seasonal fluctuations in reserves. For banks eligible for primary credit, the new DW is a “no-questions-asked” facility. Namely, the Fed no longer establishes a bank’s possible sources and needs for funding to lend under the primary credit program. Instead, primary credit for overnight maturity is allocated with minimal administrative burden on the borrower. Hence, access to primary credit need not be motivated by pressing funding needs nor signal financial weakness. In other words, there’s no structural reason why stigma should be attached to the new DW.

Nevertheless, stigma concerns resurfaced in 2007 at the onset of the recent financial crisis. In fact, as adverse liquidity conditions in the interbank markets persisted at the end of 2007, the Fed had to put in place a temporary facility, the Term Auction Facility (TAF), which was specifically designed to eliminate any perception of stigma attached to borrowing from the DW. Further, as discussed in a previous post, there’s strong evidence that banks experienced DW stigma during the most recent financial crisis.

So why do banks still feel DW stigma? In a recent staff report, we explored different hypotheses related to factors that may exacerbate or attenuate DW stigma. To conduct our analysis, we compared the DW rate with the bids each bank submitted at the TAF between December 2007 and October 2008. As explained in our paper, it can be shown with a simple arbitrage argument that, absent DW stigma, a TAF bidder should never bid above the prevailing DW rate. We therefore interpreted a bank bidding above the DW rate as evidence of DW stigma. Then, we conducted an econometric analysis to identify a bank’s possible determinants of DW stigma. Among the various hypotheses we tested, we report here the most interesting.

Banks outside the New York District: A necessary condition for DW stigma to exist is that banks must believe there’s a chance their identities will be made public soon after they borrow from the DW. Although central banks don’t immediately disclose the borrower’s identity, it’s been argued that DW borrowers may be identified from the Fed’s weekly public report, in which DW borrowings aggregated by Federal Reserve District are published. This identification channel may be especially relevant for banks in smaller Districts. Indeed, DW borrowing by an institution in a smaller District may be easier to detect. To test this hypothesis, our study focused on the Second Federal Reserve District (which covers the New York region) — the largest of the twelve Federal Reserve Districts in terms of the number of banks supervised. Consistent with the hypothesis, our results showed that banks in the New York District were 14 percent less likely to experience DW stigma than their counterparts in smaller Districts.

Foreign banks: It’s also possible that foreign institutions with access to primary credit at the Fed are especially sensitive to DW stigma. Indeed, in contrast with their U.S. counterparts, foreign banks typically don’t have access to retail dollar deposits that are insured by the Federal Deposit Insurance Corporation. As a result, foreign banks must often rely on wholesale debt investors (such as money market funds), which are highly sensitive to credit risk. In other words, because their investors may be sensitive to any negative information, foreign banks may be particularly concerned about the risk of being detected taking a loan at the DW. Again, we found strong evidence to support this hypothesis. Specifically, our results suggested that branches and agencies of foreign banks were 28 percent more likely to experience DW stigma than their U.S. counterparts with otherwise similar characteristics.

Herding effect: Intuitively, DW stigma may be expected to reflect a coordination problem. If an institution is the only one borrowing at the DW, then it’s likely to be stigmatized. However, the stigma from accessing the DW should be lower if many other institutions do so at the same time. However, we found no support for this hypothesis. Specifically, our results suggested that the stigma attached to borrowing at the DW didn’t decline when more banks accessed it during the 2007-08 period. To explore this question in more detail, we also tested whether there’s a form of herding or contagion effect, whereby a bank’s DW stigma declines when more banks within its own peer group (as measured by asset size) go to the DW. Again, the results from our regressions provided no evidence of such a herding effect.

Market conditions: In times of financial crises, there’s often intense speculation about the health of various financial institutions. In particular, public news that may be considered negative (such as a bank visit to the DW that becomes public) is likely to be amplified beyond its informational content. As a result, banks may go to greater expense to avoid borrowing at the DW. One may therefore expect DW stigma to increase when financial markets become more stressed. To test this hypothesis, our study considered three variables that capture aggregate funding conditions and volatility in financial markets: the Libor-OIS spread, a stress indicator for the interbank and money markets; the VIX level, a measure of the forward-looking volatility of the U.S. stock market as implied by options prices; and the CDX IG index of CDS prices, a measure of economy-wide default probability. Consistent with the hypothesis, we found that DW stigma was positively related to each of the three measures of stress in financial markets.

In summary, our study provided a better understanding of the reasons why banks may feel DW stigma. In particular, we found that the incidence of DW stigma was higher for foreign banks, banks that could be identified more easily, and banks outside the New York Federal Reserve District, as well as after financial markets became stressed. In contrast, we found no evidence that DW stigma may be due to a lack of coordination among banks when accessing the DW.

Disclaimer The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.

Olivier Armantier is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

The Week That Was, by Tim Duy: Plenty of data and Fedspeak to chew on last week, the sum total of which I think point in the same general direction. Economic activity is on average improving modestly, the Federal Reserve will push through with another round of tapering next week, and low inflation continues to hold back the threat of rate hikes.

After stripping out the auto component, retail sales were solid in December:

I think we are at or nearing the point where auto sales will generally move sideways and thus induce some additional volatility in the headline number. Consequently, it will be increasingly important to focus on core sales ("core" meaning less autos and gas). Looking at the three-month change, we see a modest acceleration in the back half of 2013:

Likewise, industrial production accelerated in the final months of 2013:

The initial read on consumer sentiment was modestly disappointing but not a cause for worry. In general, consumer sentiment has been weaker than what would be suggested by the pace of spending since the recovery began:

Housing starts stumbled in December after surging the previous month:

Housing activity continues to grind higher, with plenty of room left to climb. Increasingly, the gains seem likely to be coming from the single family side of the equation; multifamily has already experienced a solid rebound:

None of the above is meant to imply that we are experiencing runaway growth. Instead, the Beige Book probably sets the right tenor:

Reports from the twelve Federal Reserve Districts suggest economic activity continued to expand across most regions and sectors from late November through the end of the year. Nine Districts indicated the local economy was expanding at a moderate pace; among these, the Atlanta and Chicago Districts saw conditions improve compared with the previous reporting period. Boston and Philadelphia cited modest growth, while Kansas City reported the economy held steady in December. The economic outlook is positive in most Districts, with some reports citing expectations of "more of the same" and some expecting a pickup in growth.

The JOLTS report showed an uptick in the quits rate, something that will likely warm the heart of incoming Federal Reserve Chair Janet Yellen:

It's another quadrant of that chart that is showing improvement, which probably gives Fed officials confidence that they are moving in the right direction by slowly ending the asset purchase program. That said, inflation prevents the Fed from putting their foot on the brakes:

Until we see meaningfully higher inflation numbers, the Fed will be hesitant to deviate from their current expected rate trajectory. Putting aside any financial stability concerns, I am thinking the risk is that unemployment drops to closer to 5.5% when inflation starts to pick up, and policymakers respond with a steeper rate increase fearing they are behind the curve.

Dallas Federal Reserve President Richard Fisher offered-up another colorful speech stressing financial stability concerns. He also revealed he wanted to see the Fed cut asset purchases by $20 billion a month:

I was pleased with the decision to finally begin tapering our bond purchases, though I would have preferred to pull back our purchases by double the announced amount. But the important thing for me is that the committee began the process of slowing down the ballooning of our balance sheet, which at year-end exceeded $4 trillion. And we began—and I use that word deliberately, for we have more to do on this front—to clarify our intentions for managing the overnight money rate.

For all the concerns that the hawks will be persistent policy dissenters, Fisher does not appear to be a likely dissent just yet. For him, it is important just to know the program will end this year.

On the other side of the coin is Minneapolis Federal Reserve President Narayana Kocherlakota. In an interview with Robin Harding at the Financial Times, Kocherlakota makes clear his disappointment with the current policy trajectory:

“We’re running the risk of being content with inflation running consistently below our target. That’s inappropriate,” said Narayana Kocherlakota, who votes on Fed monetary policy this year, in an interview with the Financial Times. “Right now we’re sitting with an outlook for inflation that even by 2016 . . . is not getting back to 2 per cent.”

Importantly, he offers an alternative to the defunct Evans rule:

“We would say we intend to keep the Fed funds rate extraordinarily low in that interval between 6.5 and 5.5 per cent as long as the medium-term outlook for inflation stays sufficiently close to 2 per cent,” he said. “I definitely feel it is important to be numerical about it. Words are always subject, I think, to multiple interpretations.”

The idea of an "interval" gives some insight into the general consensus at the Fed. There does not seem to be considerable support for changing the threshold to 5.5%. Kocherlakota knows this and hopes that he can disguise changing the threshold by calling it an interval. But once you cross 6.5%, the idea of an interval is irrelevant. 5.5% becomes the focus, just as if the threshold has been changed.

Moreover, notice also the change in the inflation threshold from 2.5% to "sufficiently close" to 2%. My sense is that such a change would be interpreted hawkishly. But I think also reveals why policymakers are opposed to changing the unemployment threshold. I am thinking that below 6.5% unemployment, they are less willing to tolerate 2.5% inflation because they worry about falling behind the curve.

I think it is easier to see Kocherlakota dissenting than any of the hawks. It is clear that policy is moving fundamentally in the wrong direction in his opinion:

Mr Kocherlakota said he would not refight the Fed’s decision to taper asset purchases by about $10bn a month. “My point is simply we need to do more. If the committee chose to do that through more asset purchases that’d be fine with me. But we have to be doing more.”

The hawks might want a more rapid end to asset purchases, but at least for them policy is heading in the right direction.

San Francisco Federal Reserve President John Williams questioned the role of asset purchases as part of the Federal Reserve toolkit. Victoria McGrane at the Wall Street Journal has the story here. Williams highlights the uncertain impacts of quantitative easing:

Mr. Williams, who has been supportive of the Fed’s three rounds of bond purchases, said the measures “have proven a potent but blunt tool, with uncertain effects on financial markets and the economy.” The Fed’s bond-buying program, also known as quantitative easing, or QE, aims to lower long-term interest rates in hopes that will spur borrowing, hiring and investment.

Surveying the body of research on such bond purchases, Mr. Williams found that studies consistently find that the purchases have a significant impact on long-term bond yields but it’s harder to tell if they’re doing much to help the overall economy.

“Estimating the effects of large-scale asset purchases on the economy – as opposed to financial markets – is inherently much harder to do and is subject to greater uncertainty,” he said.

WIlliams also acknowledges the difficulties of implementing forward guidance:

“Experience has shown that it is impossible to convey the full reach of factors that influence the future course of policy. As a result, forward guidance ends up being overly simplified and prone to misinterpretation,” Mr. Williams said in his paper. What’s more, markets may not believe promises about policy made several years in advance since the policymakers making those statements could leave, he noted.

Again, isn't the Evans rule something of an oversimplification that has resulted in confusion? Perhaps a simpler target is needed:

A new framework such as nominal GDP-targeting could, in theory, could work better at communicating the Fed’s policy plans than the current approach, he said, but it might have costs as well.

And then comes the third rail of central banking:

Finally, Mr. Williams also said new research should address whether the Fed and other central banks with a 2% inflation target should aim higher. “[D]oes the 2 percent inflation target … provide a sufficient cushion to allow monetary policy to successfully stabilize the economy and inflation in the future?” he asked in his paper.

All of which sums up to: We are still learning from the crisis and thus we will see consideration of even more innovations to central banking going forward.

And last but not least, Federal Reserve Chairman Ben Bernanke made another victory lap at the inaugural event of the new Hutchins Center on Monetary Policy at the Brookings institute (also where Williams presented). For those of you with four hours to set aside, video is here.

Bottom Line: The US economy is grinding forward. Policymakers are generally comfortable with the pace of tapering at $10 billion per meeting. That could be reconsidered if we see sustained weakness in future data, but I don't think that should be the base case. Not everyone is happy at the Fed, however, and arguably the center has shifted toward the hawks as the doves are clearly not pleased that both asset purchases are ending and the Evans rule does not have an heir apparent. I think it is reasonable to believe the primary conflict at the next FOMC meeting is not over asset purchases, but on the communications strategy. The direction and nature of "enhanced forward guidance" is becoming a contentious issue now that the unemployment rate is just a breath away from the 6.5% threshold.

The process commences even before the meeting begins with a Board of Governors staffer writing up a summary of the staff’s economic and financial analyses, which are delivered at the start of each meeting.

One officer from the Board’s Division of Monetary Affairs, chosen on a rotating basis, writes up the policy discussion, in part relying on a transcript that is ready by the day after the meeting. Other staff members review the summary before sending it to Fed officials during the week following the meeting.

The Fed’s chairman is the first policy maker to review the minutes. After receiving the Fed chief’s approval, the minutes are sent to all meeting participants for comments and a revised draft is prepared by the following week.

The final draft is ready by the end of the second week. The Fed officials who can vote on interest-rate moves–the seven-person Board of Governors and five of the 12 regional bank presidents–have about four calendar days to vote to approve the minutes. The voting period ends at noon the day before the minutes are released, 21 days after the meeting.

The Fed decided to start releasing minutes three weeks after policy meetings in late 2004. Before that, the minutes were released with a longer lag. In its earliest days, the Fed kept its minutes confidential and only released a “Record of Policy Actions” once a year. Over time, the Fed decided to release more information on a more-frequent basis.

The central bank now releases full transcripts of meetings with a five-year lag.

Extra Reading: Ben Bernanke: Five Questions about the Federal Reserve and Monetary Policy

Five Questions about the Federal Reserve and Monetary Policy, Speech, Chairman Ben S. Bernanke, At the Economic Club of Indiana, Indianapolis, Indiana, October 1, 2012: Good afternoon. I am pleased to be able to join the Economic Club of Indiana for lunch today. I note that the mission of the club is "to promote an interest in, and enlighten its membership on, important governmental, economic and social issues." I hope my remarks today will meet that standard. Before diving in, I'd like to thank my former colleague at the White House, Al Hubbard, for helping to make this event possible. As the head of the National Economic Council under President Bush, Al had the difficult task of making sure that diverse perspectives on economic policy issues were given a fair hearing before recommendations went to the President. Al had to be a combination of economist, political guru, diplomat, and traffic cop, and he handled it with great skill.

My topic today is "Five Questions about the Federal Reserve and Monetary Policy." I have used a question-and-answer format in talks before, and I know from much experience that people are eager to know more about the Federal Reserve, what we do, and why we do it. And that interest is even broader than one might think. I'm a baseball fan, and I was excited to be invited to a recent batting practice of the playoff-bound Washington Nationals. I was introduced to one of the team's star players, but before I could press my questions on some fine points of baseball strategy, he asked, "So, what's the scoop on quantitative easing?" So, for that player, for club members and guests here today, and for anyone else curious about the Federal Reserve and monetary policy, I will ask and answer these five questions:

What are the Fed's objectives, and how is it trying to meet them?

What's the relationship between the Fed's monetary policy and the fiscal decisions of the Administration and the Congress?

What is the risk that the Fed's accommodative monetary policy will lead to inflation?

How does the Fed's monetary policy affect savers and investors?

How is the Federal Reserve held accountable in our democratic society?

What Are the Fed's Objectives, and How Is It Trying to Meet Them? The first question on my list concerns the Federal Reserve's objectives and the tools it has to try to meet them.

As the nation's central bank, the Federal Reserve is charged with promoting a healthy economy--broadly speaking, an economy with low unemployment, low and stable inflation, and a financial system that meets the economy's needs for credit and other services and that is not itself a source of instability. We pursue these goals through a variety of means. Together with other federal supervisory agencies, we oversee banks and other financial institutions. We monitor the financial system as a whole for possible risks to its stability. We encourage financial and economic literacy, promote equal access to credit, and advance local economic development by working with communities, nonprofit organizations, and others around the country. We also provide some basic services to the financial sector--for example, by processing payments and distributing currency and coin to banks.

But today I want to focus on a role that is particularly identified with the Federal Reserve--the making of monetary policy. The goals of monetary policy--maximum employment and price stability--are given to us by the Congress. These goals mean, basically, that we would like to see as many Americans as possible who want jobs to have jobs, and that we aim to keep the rate of increase in consumer prices low and stable.

In normal circumstances, the Federal Reserve implements monetary policy through its influence on short-term interest rates, which in turn affect other interest rates and asset prices.1 Generally, if economic weakness is the primary concern, the Fed acts to reduce interest rates, which supports the economy by inducing businesses to invest more in new capital goods and by leading households to spend more on houses, autos, and other goods and services. Likewise, if the economy is overheating, the Fed can raise interest rates to help cool total demand and constrain inflationary pressures.

Following this standard approach, the Fed cut short-term interest rates rapidly during the financial crisis, reducing them to nearly zero by the end of 2008--a time when the economy was contracting sharply. At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy tool for dealing with economic weakness was no longer available. Yet, with unemployment soaring, the economy and job market clearly needed more support. Central banks around the world found themselves in a similar predicament. We asked ourselves, "What do we do now?"

To answer this question, we could draw on the experience of Japan, where short-term interest rates have been near zero for many years, as well as a good deal of academic work. Unable to reduce short-term interest rates further, we looked instead for ways to influence longer-term interest rates, which remained well above zero. We reasoned that, as with traditional monetary policy, bringing down longer-term rates should support economic growth and employment by lowering the cost of borrowing to buy homes and cars or to finance capital investments. Since 2008, we've used two types of less-traditional monetary policy tools to bring down longer-term rates.

The first of these less-traditional tools involves the Fed purchasing longer-term securities on the open market--principally Treasury securities and mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The Fed's purchases reduce the amount of longer-term securities held by investors and put downward pressure on the interest rates on those securities. That downward pressure transmits to a wide range of interest rates that individuals and businesses pay. For example, when the Fed first announced purchases of mortgage-backed securities in late 2008, 30-year mortgage interest rates averaged a little above 6percent; today they average about 3-1/2 percent. Lower mortgage rates are one reason for the improvement we have been seeing in the housing market, which in turn is benefiting the economy more broadly. Other important interest rates, such as corporate bond rates and rates on auto loans, have also come down. Lower interest rates also put upward pressure on the prices of assets, such as stocks and homes, providing further impetus to household and business spending.

The second monetary policy tool we have been using involves communicating our expectations for how long the short-term interest rate will remain exceptionally low. Because the yield on, say, a five-year security embeds market expectations for the course of short-term rates over the next five years, convincing investors that we will keep the short-term rate low for a longer time can help to pull down market-determined longer-term rates. In sum, the Fed's basic strategy for strengthening the economy--reducing interest rates and easing financial conditions more generally--is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly.

Last month, my colleagues and I used both tools--securities purchases and communications about our future actions--in a coordinated way to further support the recovery and the job market. Why did we act? Though the economy has been growing since mid-2009 and we expect it to continue to expand, it simply has not been growing fast enough recently to make significant progress in bringing down unemployment. At 8.1 percent, the unemployment rate is nearly unchanged since the beginning of the year and is well above normal levels. While unemployment has been stubbornly high, our economy has enjoyed broad price stability for some time, and we expect inflation to remain low for the foreseeable future. So the case seemed clear to most of my colleagues that we could do more to assist economic growth and the job market without compromising our goal of price stability.

Specifically, what did we do? On securities purchases, we announced that we would buy mortgage-backed securities guaranteed by the government-sponsored enterprises at a rate of $40 billion per month. Those purchases, along with the continuation of a previous program involving Treasury securities, mean we are buying $85 billion of longer-term securities per month through the end of the year. We expect these purchases to put further downward pressure on longer-term interest rates, including mortgage rates. To underline the Federal Reserve's commitment to fostering a sustainable economic recovery, we said that we would continue securities purchases and employ other policy tools until the outlook for the job market improves substantially in a context of price stability.

In the category of communications policy, we also extended our estimate of how long we expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015. That doesn't mean that we expect the economy to be weak through 2015. Rather, our message was that, so long as price stability is preserved, we will take care not to raise rates prematurely. Specifically, we expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens. We hope that, by clarifying our expectations about future policy, we can provide individuals, families, businesses, and financial markets greater confidence about the Federal Reserve's commitment to promoting a sustainable recovery and that, as a result, they will become more willing to invest, hire and spend.

Now, as I have said many times, monetary policy is no panacea. It can be used to support stronger economic growth in situations in which, as today, the economy is not making full use of its resources, and it can foster a healthier economy in the longer term by maintaining low and stable inflation. However, many other steps could be taken to strengthen our economy over time, such as putting the federal budget on a sustainable path, reforming the tax code, improving our educational system, supporting technological innovation, and expanding international trade. Although monetary policy cannot cure the economy's ills, particularly in today's challenging circumstances, we do think it can provide meaningful help. So we at the Federal Reserve are going to do what we can do and trust that others, in both the public and private sectors, will do what they can as well.

What's the Relationship between Monetary Policy and Fiscal Policy? That brings me to the second question: What's the relationship between monetary policy and fiscal policy? To answer this question, it may help to begin with the more basic question of how monetary and fiscal policy differ.

In short, monetary policy and fiscal policy involve quite different sets of actors, decisions, and tools. Fiscal policy involves decisions about how much the government should spend, how much it should tax, and how much it should borrow. At the federal level, those decisions are made by the Administration and the Congress. Fiscal policy determines the size of the federal budget deficit, which is the difference between federal spending and revenues in a year. Borrowing to finance budget deficits increases the government's total outstanding debt.

As I have discussed, monetary policy is the responsibility of the Federal Reserve--or, more specifically, the Federal Open Market Committee, which includes members of the Federal Reserve's Board of Governors and presidents of Federal Reserve Banks. Unlike fiscal policy, monetary policy does not involve any taxation, transfer payments, or purchases of goods and services. Instead, as I mentioned, monetary policy mainly involves the purchase and sale of securities. The securities that the Fed purchases in the conduct of monetary policy are held in our portfolio and earn interest. The great bulk of these interest earnings is sent to the Treasury, thereby helping reduce the government deficit. In the past three years, the Fed remitted $200 billion to the federal government. Ultimately, the securities held by the Fed will mature or will be sold back into the market. So the odds are high that the purchase programs that the Fed has undertaken in support of the recovery will end up reducing, not increasing, the federal debt, both through the interest earnings we send the Treasury and because a stronger economy tends to lead to higher tax revenues and reduced government spending (on unemployment benefits, for example).

Even though our activities are likely to result in a lower national debt over the long term, I sometimes hear the complaint that the Federal Reserve is enabling bad fiscal policy by keeping interest rates very low and thereby making it cheaper for the federal government to borrow. I find this argument unpersuasive. The responsibility for fiscal policy lies squarely with the Administration and the Congress. At the Federal Reserve, we implement policy to promote maximum employment and price stability, as the law under which we operate requires. Using monetary policy to try to influence the political debate on the budget would be highly inappropriate. For what it's worth, I think the strategy would also likely be ineffective: Suppose, notwithstanding our legal mandate, the Federal Reserve were to raise interest rates for the purpose of making it more expensive for the government to borrow. Such an action would substantially increase the deficit, not only because of higher interest rates, but also because the weaker recovery that would result from premature monetary tightening would further widen the gap between spending and revenues. Would such a step lead to better fiscal outcomes? It seems likely that a significant widening of the deficit--which would make the needed fiscal actions even more difficult and painful--would worsen rather than improve the prospects for a comprehensive fiscal solution.

I certainly don't underestimate the challenges that fiscal policymakers face. They must find ways to put the federal budget on a sustainable path, but not so abruptly as to endanger the economic recovery in the near term. In particular, the Congress and the Administration will soon have to address the so-called fiscal cliff, a combination of sharply higher taxes and reduced spending that is set to happen at the beginning of the year. According to the Congressional Budget Office and virtually all other experts, if that were allowed to occur, it would likely throw the economy back into recession. The Congress and the Administration will also have to raise the debt ceiling to prevent the Treasury from defaulting on its obligations, an outcome that would have extremely negative consequences for the country for years to come. Achieving these fiscal goals would be even more difficult if monetary policy were not helping support the economic recovery.

What Is the Risk that the Federal Reserve's Monetary Policy Will Lead to Inflation? A third question, and an important one, is whether the Federal Reserve's monetary policy will lead to higher inflation down the road. In response, I will start by pointing out that the Federal Reserve's price stability record is excellent, and we are fully committed to maintaining it. Inflation has averaged close to 2 percent per year for several decades, and that's about where it is today. In particular, the low interest rate policies the Fed has been following for about five years now have not led to increased inflation. Moreover, according to a variety of measures, the public's expectations of inflation over the long run remain quite stable within the range that they have been for many years.

With monetary policy being so accommodative now, though, it is not unreasonable to ask whether we are sowing the seeds of future inflation. A related question I sometimes hear--which bears also on the relationship between monetary and fiscal policy, is this: By buying securities, are you "monetizing the debt"--printing money for the government to use--and will that inevitably lead to higher inflation? No, that's not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size. Moreover, the way the Fed finances its securities purchases is by creating reserves in the banking system. Increased bank reserves held at the Fed don't necessarily translate into more money or cash in circulation, and, indeed, broad measures of the supply of money have not grown especially quickly, on balance, over the past few years.

For controlling inflation, the key question is whether the Federal Reserve has the policy tools to tighten monetary conditions at the appropriate time so as to prevent the emergence of inflationary pressures down the road. I'm confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. For example, the Fed can tighten policy, even if our balance sheet remains large, by increasing the interest rate we pay banks on reserve balances they deposit at the Fed. Because banks will not lend at rates lower than what they can earn at the Fed, such an action should serve to raise rates and tighten credit conditions more generally, preventing any tendency toward overheating in the economy.

Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to "take away the punch bowl" is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools. I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions.

How Does the Fed's Monetary Policy Affect Savers and Investors? The concern about possible inflation is a concern about the future. One concern in the here and now is about the effect of low interest rates on savers and investors. My colleagues and I know that people who rely on investments that pay a fixed interest rate, such as certificates of deposit, are receiving very low returns, a situation that has involved significant hardship for some.

However, I would encourage you to remember that the current low levels of interest rates, while in the first instance a reflection of the Federal Reserve's monetary policy, are in a larger sense the result of the recent financial crisis, the worst shock to this nation's financial system since the 1930s. Interest rates are low throughout the developed world, except in countries experiencing fiscal crises, as central banks and other policymakers try to cope with continuing financial strains and weak economic conditions.

A second observation is that savers often wear many economic hats. Many savers are also homeowners; indeed, a family's home may be its most important financial asset. Many savers are working, or would like to be. Some savers own businesses, and--through pension funds and 401(k) accounts--they often own stocks and other assets. The crisis and recession have led to very low interest rates, it is true, but these events have also destroyed jobs, hamstrung economic growth, and led to sharp declines in the values of many homes and businesses. What can be done to address all of these concerns simultaneously? The best and most comprehensive solution is to find ways to a stronger economy. Only a strong economy can create higher asset values and sustainably good returns for savers. And only a strong economy will allow people who need jobs to find them. Without a job, it is difficult to save for retirement or to buy a home or to pay for an education, irrespective of the current level of interest rates.

The way for the Fed to support a return to a strong economy is by maintaining monetary accommodation, which requires low interest rates for a time. If, in contrast, the Fed were to raise rates now, before the economic recovery is fully entrenched, house prices might resume declines, the values of businesses large and small would drop, and, critically, unemployment would likely start to rise again. Such outcomes would ultimately not be good for savers or anyone else.

How Is the Federal Reserve Held Accountable in a Democratic Society? I will turn, finally, to the question of how the Federal Reserve is held accountable in a democratic society.

The Federal Reserve was created by the Congress, now almost a century ago. In the Federal Reserve Act and subsequent legislation, the Congress laid out the central bank's goals and powers, and the Fed is responsible to the Congress for meeting its mandated objectives, including fostering maximum employment and price stability. At the same time, the Congress wisely designed the Federal Reserve to be insulated from short-term political pressures. For example, members of the Federal Reserve Board are appointed to staggered, 14-year terms, with the result that some members may serve through several Administrations. Research and practical experience have established that freeing the central bank from short-term political pressures leads to better monetary policy because it allows policymakers to focus on what is best for the economy in the longer run, independently of near-term electoral or partisan concerns. All of the members of the Federal Open Market Committee take this principle very seriously and strive always to make monetary policy decisions based solely on factual evidence and careful analysis.

It is important to keep politics out of monetary policy decisions, but it is equally important, in a democracy, for those decisions--and, indeed, all of the Federal Reserve's decisions and actions--to be undertaken in a strong framework of accountability and transparency. The American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayer resources.

One of my principal objectives as Chairman has been to make monetary policy at the Federal Reserve as transparent as possible. We promote policy transparency in many ways. For example, the Federal Open Market Committee explains the reasons for its policy decisions in a statement released after each regularly scheduled meeting, and three weeks later we publish minutes with a detailed summary of the meeting discussion. The Committee also publishes quarterly economic projections with information about where we anticipate both policy and the economy will be headed over the next several years. I hold news conferences four times a year and testify often before congressional committees, including twice-yearly appearances that are specifically designated for the purpose of my presenting a comprehensive monetary policy report to the Congress. My colleagues and I frequently deliver speeches, such as this one, in towns and cities across the country.

The Federal Reserve is also very open about its finances and operations. The Federal Reserve Act requires the Federal Reserve to report annually on its operations and to publish its balance sheet weekly. Similarly, under the financial reform law enacted after the financial crisis, we publicly report in detail on our lending programs and securities purchases, including the identities of borrowers and counterparties, amounts lent or purchased, and other information, such as collateral accepted. In late 2010, we posted detailed information on our public website about more than 21,000 individual credit and other transactions conducted to stabilize markets during the financial crisis. And, just last Friday, we posted the first in an ongoing series of quarterly reports providing a great deal of information on individual discount window loans and securities transactions. The Federal Reserve's financial statement is audited by an independent, outside accounting firm, and an independent Inspector General has wide powers to review actions taken by the Board. Importantly, the Government Accountability Office (GAO) has the ability to--and does--oversee the efficiency and integrity of all of our operations, including our financial controls and governance.

While the GAO has access to all aspects of the Fed's operations and is free to criticize or make recommendations, there is one important exception: monetary policymaking. In the 1970s, the Congress deliberately excluded monetary policy deliberations, decisions, and actions from the scope of GAO reviews. In doing so, the Congress carefully balanced the need for democratic accountability with the benefits that flow from keeping monetary policy free from short-term political pressures.

However, there have been recent proposals to expand the authority of the GAO over the Federal Reserve to include reviews of monetary policy decisions. Because the GAO is the investigative arm of the Congress and GAO reviews may be initiated at the request of members of the Congress, these reviews (or the prospect of reviews) of individual policy decisions could be seen, with good reason, as efforts to bring political pressure to bear on monetary policymakers. A perceived politicization of monetary policy would reduce public confidence in the ability of the Federal Reserve to make its policy decisions based strictly on what is good for the economy in the longer term. Balancing the need for accountability against the goal of insulating monetary policy from short-term political pressure is very important, and I believe that the Congress had it right in the 1970s when it explicitly chose to protect monetary policy decision making from the possibility of politically motivated reviews.

Conclusion In conclusion, I will simply note that these past few years have been a difficult time for the nation and the economy. For its part, the Federal Reserve has also been tested by unprecedented challenges. As we approach next year's 100th anniversary of the signing of the Federal Reserve Act, however, I have great confidence in the institution. In particular, I would like to recognize the skill, professionalism, and dedication of the employees of the Federal Reserve System. They work tirelessly to serve the public interest and to promote prosperity for people and businesses across America. The Fed's policy choices can always be debated, but the quality and commitment of the Federal Reserve as a public institution is second to none, and I am proud to lead it.

Now that I've answered questions that I've posed to myself, I'd be happy to respond to yours.

1. The Fed has a number of ways to influence short-term rates; basically, they involve steps to affect the supply, and thus the cost, of short-term funding.

Chapter 12 Structure of Central Banks and the Federal Reserve System [We may start this section, but we won't get too far if we do.]

Origins of the Federal Reserve System

Distribute power to geographic regions, the public sector, the private sector, the business sector, and the financial sector

Formal Structure of the Federal Reserve System

Federal Reserve Banks

Member Banks

Board of Governors of the Federal Reserve System

Federal Open Market Committee (FOMC)

The Federal Advisory Council (FAC)

Informal Structure of the Federal Reserve System

How Power Has Been Centralized Over Time

Video

Material from class:

Extra Reading:

The stone money of Yap is an interesting case to consider when thinking about what money is and what role it plays in the economic and social affairs of a community. This article by Michael Bryan of the Federal Reserve Bank of Cleveland describes the stone wheels of Yap, how they were obtained and used as gift markers both within and between tribes, and whether the stones fit the textbook definition of money:

Federal Reserve Bank of Cleveland, Island Money, by Michael F. Bryan: ...In this Commentary, I … consider… the unique and curious money of Yap, a small group of islands in the South Pacific. … For at least a few centuries leading up to today, the Yapese have used giant stone wheels called rai when executing certain exchanges. The stones are made from a shimmering limestone that is not indigenous to Yap, but quarried and shipped, primarily from the islands of Palau, 250 miles to the southwest. The size of the stones varies; some are as small as a few inches in diameter and weigh a couple of pounds, while others may reach a diameter of 12 feet and weigh thousands of pounds. A hole is carved into the middle of each stone so that it may be carried, either by coconut rope strung through the smaller pieces, or by wooden poles inserted into the larger stones. These great stones require the combined effort of many men to lift. Expeditions to acquire new stones were authorized by a chief who would retain all of the larger stones and two-fifths of the smaller ones, reportedly a fairly common distribution of production that served as a tax on the Yapese. In effect, the Yap chiefs acted as the island’s central bankers; they controlled the quantity of stones in circulation...

The quarrying and transport of rai was a substantial part of the Yapese economy. In 1882, British naturalist Jan S. Kubary reported seeing 400 Yapese men producing stones on the island of Palau for transport back to Yap. Given the population of the island at the time … more than 10 percent of the island’s adult male population was in the money-cutting business. Curiously, rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money. Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established...

Precisely how the value of each stone was determined is somewhat unclear. We know that size was at best only a rough approximation of worth and that stone values varied depending upon the cost or difficulty of bringing them to the island. For example, stones gotten at great peril, perhaps even loss of life, are valued most highly. Similarly, stones that were cut using shell tools and carried by canoes are more valuable than comparably sized stones that were quarried with the aid of iron tools and transported by large Western ships. The more valuable stones were given names, such as that of the chief for whom the stone was quarried or the canoe on which it was transported. Naming the stone may have secured its value since such identification would convey to all the costs associated with obtaining it...

Consider the case of the Irish American David O’Keefe from Savannah, Georgia, who, after being shipwrecked on Yap in the late nineteenth century, returned to the island with a sailing vessel and proceeded to import a large number of stones in return for a bounty of Yapese copra (coconut meat). The arrival of O’Keefe (and other Western traders) increased the number and size of the stones being brought back to the island, and by one accounting, Yap stones went from being “very rare” in 1840 to being plentiful—more than 13,000 were to be found on the island by 1929. No longer restricted by shell tools and canoes, the largest stones arriving grew from four feet in diameter to the colossal 12-foot stones that are now a part of monetary folklore. Yet the great infusion of stones did not inflate away their value. Since the stones of Captain O’Keefe were obviously more easily obtained, they traded on the island at an appropriately reduced value relative to the older stones gotten at much greater cost. In essence, O’Keefe and other Westerners were bringing in large numbers of “debased” stones that could easily be identified by the Yapese.

While it’s clear that the Yap stones have value for the Yapese, can the stones really be called money? The answer, of course, depends upon how you define money. If you rely on a standard textbook definition, you’d describe money in terms of its functions, for example, “Whatever is used as a medium of exchange, unit of account, and store of value.” Certainly, Yap stones performed at least one of these functions quite well—they were an effective store of value (form of wealth). But every asset—from bonds to houses—stores value and is not necessarily labeled money.

To be called money, at least according to the textbook definition, an asset must serve two other functions. It must be a medium of exchange, meaning that it can be readily used either to purchase goods or to satisfy a debt, and it must be a unit of account, or something used as a measure of value. Yap stones were not the unit of account for the islands. Pricing goods and services in terms of the stones would probably have been difficult for the average islander. ... According to Paul Einzig, prices on the islands were set in terms of baskets of a food crop, taro, or cups of syrup, staples that would be easy for a typical islander to appreciate. Furthermore, there is some question whether Yap stones were commonly used as a medium of exchange. To be used in exchange, an item must possess certain characteristics—it must be storable, portable, recognizable, and divisible. Certainly, the stones were storable; they can still be found in abundance on Yap, and they have maintained their purchasing power reasonably well over time (particularly compared with other fiat monies, including dollars). And while it is sometimes claimed that Yap stones suffer as an exchange medium because they lack portability, this may not be completely accurate. In the case of the larger, more easily identified stones, physical possession is not necessary for the transfer of purchasing power. Those involved in the exchange need only communicate that purchasing power has been transferred…

But while storability and portability may not have limited the use of these stones as a medium of exchange, the other two characteristics—recognizability and divisibility—probably did. The stones were primarily used in exchanges between Yap islanders. … Yap historically did not have close cultural ties with any of its trading partners and trade with off-islanders was somewhat infrequent, the stones did not facilitate transactions on these occasions. When transacting with other islands, the Yapese used woven mats (a common exchange medium throughout the South Pacific), while trade with Westerners often involved an exchange of coconuts. Even on the island, the indivisibility of the stones necessitated the use of other items as media of exchange for most transactions. Most rai are highly valued: By one account, a stone of “three spans” (about 25 inches across) would have been sufficient in the early twentieth century to purchase 50 baskets of food or a full-sized pig, while a stone the size of a man would have been worth “many villages and plantations.” Obviously, these stones do not change hands very frequently, since expenditures of such magnitude are rare. For more ordinary transactions, the Yapese either used pearl shells or resorted to barter. Clearly the stones of Yap do not fit neatly within the textbook definition of money…

But … what role do the stones play and how is that role similar to that played by dollars?... [T]he stones, particularly the larger ones, acted as markers, changing hands in recognition of a “gift.” Stones were often merely held until the gift was reciprocated and the stone could be returned to its original owner. For example, islanders wishing to fish someone’s waters might do so by leaving a stone in recognition of the favor. After an appropriate number of fish were given to the owner of the fishing waters, the stone would simply be reclaimed. Occasionally a stone was “exchanged” when one tribe came to the aid of another, say for support against a rival tribe or in celebration of some event. But the stone would reside with the new tribe only until such time as aid of a similar value could be given in return. The stones, then, act as a memory of the contributions occurring between islanders. Anthropologists refer to this as a “gift economy,” where goods aren’t traded as much as they are given with the expectation of a comparable favor at some later date. So Yap stones serve as a memory of one’s contributions on the island. … But this raises an intriguing question. If the stones of Yap were merely markers and nothing more, why did the Yapese expend such great resources to carve them out of the mountains of Palau and carry them all the way back to their island? Wouldn’t any marker work just as well? It may be that the Yap chiefs did not have sufficient “credibility” to simply decree an object’s value. That is, the Yapese may have needed some assurance that the object on which value has been assigned could not be easily replicated for the mere benefit of the issuer...

Before independence, America's disparate colonial economies struggled with a very material financial hang-up: there just wasn't enough money to go around. Colonial governments attempted to solve this problem by using tobacco, nails, and animal pelts for currency, assigning them a set amount of shillings or pennies so that they could intermix with the existing system.

The most successful ad hoc currency was wampum, a particular kind of bead made from the shells of ocean critters. But eventually the value of this currency, like that of other alternative currencies of the day, was undermined by oversupply and counterfeiting. (That's right: counterfeit wampum. They were produced by dyeing like-shaped shells with berry juice, mimicking the purple color of the real thing.)

It was a crew of Puritans from Boston who first put their faith in paper. Initially, the Massachusetts Bay Colony tried to issue colonial coinage. The pieces themselves, struck in 1652, were made from a mash-up of poor-quality silver and were soon outlawed by the Brits. Less than a decade later the colonists tried again. They were forced to, really, because they owed money to the crown to help fund Britain's war against France, yet lacked any currency with which to pay up. They called the paper "bills of credit." The local government essentially said to the people: Here, just use this. It's real money. We'll sort out redeemability later.

There were endless debates, from prairie farmlands to the floor of Congress, about whether this paper was real money or just a smoke-and-mirrors scheme destined to end badly. ...[continue]...

November 28, 2012

A Little Less Dovish..., by Tim Duy: In the midst of an internal debate over
policy communication, Chicago Federal Reserve President Charles Evans pulled
back on his 3 percent inflation threshold
in a speech yesterday. Arguably, as the only policymaker suggesting
guidance well above the Fed's stated 2 percent target, Evans was
the last true dove at the Fed. With Evan's falling in line with his
colleagues, it looks like the last sliver of hope that the Fed would tolerate
slightly higher inflation to accelerate the reduction of real burden has now
been dashed.

There is a lot of interesting material in Evan's speech, but here I focus
only on his basic outlook and the implications for policy. Regarding growth:

That said, monetary policymakers must formulate policy for today. In the
United States, forecasts by both private analysts and FOMC participants see real
GDP growth in 2012 coming in at a bit under 2 percent. Growth is expected to
move moderately higher in 2013, but only to a pace that is just somewhat above
potential. Such growth would likely generate only a small decline in the
unemployment rate.

Of course, he added earlier that this forecast is vulnerable to the possible
of an austerity bomb in 2013, but for the moment assume that issue is resolved:

Having said all that, most forecasters are predicting that the pace of growth
will pick up as we move through next year and into 2014. Underlying these
projections is an assumption that fiscal disaster will be avoided—and with this,
that some important uncertainties restraining growth should come off the table.
Also, deleveraging will run its course, and as it does, the economy’s
more-typical cyclical recovery dynamics will take over. As the FOMC indicated in
its policy moves last September, the current highly accommodative stance for
monetary policy will be kept in place for some time to come.

He then praises recent policy actions:

Tying the length of time over which our purchases will be made to economic
conditions is an important step. Because it clarifies how our policy decisions
are conditional on progress made toward our dual mandate goals, markets can be
more confident that we will provide the monetary accommodation necessary to
close the large resource gaps that currently exist; additionally, markets can be
more certain that we will not wait too long to tighten if inflation were to
become an important concern.

And then tackles a big question:

The natural question at this point is to ask: What constitutes substantial
improvement in labor markets? Personally, I think we would need to see several
things. The first would be increases in payrolls of at least 200,000 per month
for a period of around six months. We also would need to see a faster pace of
GDP growth than we have now — something noticeably above the economy’s potential
rate of growth.

From Evan's perspective, these conditions would be sufficient to end the
expansion of the balance sheet, although interest rates will remain near zero
beyond that point. When should rates rise?

Of course, we will not maintain low rates indefinitely. For some time, I have
advocated the use of specific, numerical thresholds to describe the economic
conditions that would have to occur before it might be appropriate to begin
raising rates.

On the employment mandate:

In the past, I have said we should hold the fed funds rate near zero at least
as long as the unemployment rate is above 7 percent and as long as inflation is
below 3 percent. I now think the 7 percent threshold is too conservative....This
logic is supported by a number of macro-model simulations I have seen, which
indicate that we can keep the funds rate near zero until the unemployment rate
hits at least 6-1/2 percent and still generate only minimal inflation risks.

So he shifts to a 6.5 percent threshold for unemployment, and later argues
that even this might be a bit conservative as his models don't foresee much
inflation pressure before 6 percent. See also Federal reserve Janet Yellen's
recent speech; Evans' view is consistent with the optimal path forecasts. On
one hand this is somewhat of a shift to the dovish side on the inflation
forecast, suggesting that inflation will not accelerate as quickly as some might
expect. What about the threshold for the rate of inflation itself?

With regard to the inflation safeguard, I have previously discussed how the 3
percent threshold is a symmetric and reasonable treatment of our 2 percent
target. This is consistent with the usual fluctuations in inflation and the
range of uncertainty over its forecasts. But I am aware that the 3 percent
threshold makes many people anxious. The simulations I mentioned earlier suggest
that setting a lower inflation safeguard is not likely to impinge too much on
the policy stimulus generated by a 6-1/2 percent unemployment rate threshold.
Indeed, we’re much more likely to reach the 6-1/2 percent unemployment threshold
before inflation begins to approach even a modest number like 2-1/2 percent.

So, given the recent policy actions and analyses I mentioned, I have
reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent
for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured
in terms of the outlook for total PCE (Personal Consumption Expenditures Pride
Index) inflation over the next two to three years, would be appropriate.

Notice that he really doesn't have a reason to shift his threshold; he
doesn't even expect to hit the inflation threshold before hitting the employment
threshold. His reason for essentially is that the 3 percent threshold makes
people "anxious." Anxious about what? Anything that is perceived to be a
threat to the Fed's credibility.

Does this shift on Evans' part really change anything? Probably not. He was
always an outlier among Fed policymakers, with a tolerance for inflation as high
as 3 percent making him a true dove. But he was never going to get any
additional traction on that front from his colleagues. The 2 percent target is
set in stone, and it is too much to expect the Fed will tolerate any meaningful
deviations from that target. Of course, it is questionable that 3 percent is a
meaningful deviation to begin with, but that is question is almost irrelevant at
this point.

Bottom Line: By shifting his threshold on inflation, Evan's concedes to the
political realities within the Fed. There was never much support for anything
like tolerance for 3 percent inflation; for most policymakers, I suspect
anything above 2.25 percent would be considered a threat to credibility. By
falling in line with the rest of the FOMC, Evan abandons his role as a true
dove, someone willing to tolerate substantially higher inflation. He is a dove
now in the modern sense - a policymaker with a lower inflation forecast that
allows for a longer period of easier policy.

This Economic Letter from the SF Fed is on government spending multipliers:

Highway Grants: Roads to Prosperity?, by Sylvain Leduc and Daniel Wilson, FRBSF: Increasing government spending during periods of economic weakness to
offset slower private-sector spending has long been an important policy
tool. In particular, during the recent recession and slow recovery,
federal officials put in place fiscal measures, including increased
government spending, to boost economic growth and lower unemployment.
One form of government spending that has received a lot of attention is
public investment in infrastructure projects. The 2009 American Recovery
and Reinvestment Act (ARRA) allocated $40 billion to the Department of
Transportation for spending on the nation’s roads and other public
infrastructure. Such public infrastructure investment harks back to the
Great Depression, when programs such as the Works Progress
Administration and the Tennessee Valley Authority were inaugurated.

One criticism of public infrastructure programs is that they take a
long time to put in place and therefore are unlikely to be effective
quickly enough to alleviate economic downturns. The fact is, though,
that surprisingly little empirical information is available about the
effect of public infrastructure investment on economic activity over the
short and medium term.

This Economic Letter examines new research (Leduc and Wilson,
forthcoming) on the dynamic effects of public investment in roads and
highways on gross state product (GSP), the total economic output of a
state. This research focuses on investment in roads and highways in part
because it is the largest component of public infrastructure in the
United States. Moreover, the procedures by which federal highway grants
are distributed to states help us identify more precisely how
transportation spending affects economic activity.

We find that unanticipated increases in highway spending have positive
but temporary effects on GSP, both in the short and medium run. The
short-run effect is consistent with a traditional Keynesian channel in
which output increases because of a rise in aggregate demand, combined
with slow-to-adjust prices. In contrast, the positive response of GSP
over the medium run is in line with a supply-side effect due to an
increase in the economy’s productive capacity.

We also assess how much bang each additional buck of highway spending
creates by calculating the multiplier, that is, the magnitude of the
effect of each dollar of infrastructure spending on economic activity.
We find that the multiplier is at least two. In other words, for each
dollar of federal highway grants received by a state, that state’s GSP
rises by at least two dollars.

The Federal-Aid Highway Program

The federal government’s involvement in financing road construction
goes back to the early part of the past century. Although initially
small, this involvement became much more significant in 1956 with the
enactment of the Federal-Aid Highway Act, which authorized almost $34
billion in 1956 dollars over 13 years for the construction of the
Interstate Highway System. At the time, The New York Times noted that
“the highway program will constitute a growing and ever-more-important
share of the gross national product … (affecting) every phase of
economic life in this country.”

The Interstate Highway System was completed in 1992. Since then, the
federal government has continued to provide funding to states mostly
through a series of grant programs collectively known as the Federal-Aid
Highway Program (FAHP). The FAHP helps fund construction, maintenance,
and other improvements on a wide range of public roads beyond the
interstate highways. Local roads are often considered federal-aid
highways and are eligible for federal funding, depending on how
important the federal government judges them to be.

Because road projects typically take a long time to complete, advance
knowledge of future funding sources can help smooth planning. Congress
designs transportation legislation to minimize uncertainty. First, it
enacts legislation that typically extends five to six years. Second, it
apportions funds to states according to set formulas. Thus, a typical
highway bill will specify an annual national amount for each highway
program over the life of the legislation and spell out the formula by
which that program’s national amount will be apportioned to states.
Importantly, these formulas are based on road-related metrics measured
several years earlier. That means that changes to current and future
highway funding are not driven by current economic conditions.

Highway bills generally include information that helps states forecast
relatively accurately the amount of grants they are likely to receive
while the legislation is in effect. For the past two highway bills, the
Federal Highway Administration (FHWA) published forecasts of each
state’s annual future grants under each program.

Estimating the effects of road spending

We conduct a statistical analysis to estimate the effects of federal
highway spending on state economic activity. Specifically, we construct a
variable that captures revisions to forecasts of current and future
highway grants to the states, based on information from highway bills
since 1991. We closely follow, but also expand on, the FHWA’s
methodology for forecasting each state’s future grants.

These forecast revisions serve as proxies for changes in expectations
about current and future highway spending in a given state. In economic
terms, these changes can be regarded as shocks, that is, unanticipated
events that affect economic activity.

We study forecast revisions rather than changes in actual highway
spending for two reasons. First, actual spending may both affect and be
affected by current economic conditions, making it difficult to sort out
the true causal effects of the spending.

Second, changes in actual spending are most likely to be anticipated
years in advance. For that reason, some of their economic effects may be
felt before the spending changes actually take place. For instance, a
state government and other important players, such as construction and
engineering firms, may decide to spend more today if they expect the
state to receive more highway grants in the future. In this way, changes
in expectations regarding future grants to the states may be important
for current economic activity. Failing to account for changes in
expectations may lead to incorrect conclusions about how government
spending affects economic activity (see Ramey 2011a).

Figure 1
Average response of state GDPs to unexpected grants

In our analysis of how changes in forecasts of highway grants to the
states affect state GSP, we control for lags in state GSP, lags in
receipt of highway grants, average state GSP levels, and national
movements of gross domestic product (GDP) over the sample period from
1990 to 2010.

In Figure 1, the solid line shows the average percentage change in a
state’s GSP following a 1% increase in forecasted future highway grants
to the states. The shaded area around the line represents a 90%
probability range. The horizontal axis indicates the number of years
after the unanticipated change in forecasted highway grants to the
states. The figure shows that changes in the forecasts have a
significant short-term effect on state output in the first one to two
years. This effect fades, but then increases sharply six to eight years
after the forecast revisions, before declining again. This pattern holds
up well with alternative estimation techniques, the inclusion of
different control variables, and with different data samples.

This pattern is consistent with New Keynesian theoretical models in
which public infrastructure, such as roads, are used by the private
sector in the production of goods and services and take time to be built
(see Leduc and Wilson, forthcoming). In this framework, the initial
impact is due to a traditional Keynesian effect of an increase in
aggregate demand. The medium-term effect on output arises once the
public infrastructure is built, thus increasing the economy’s productive
capacity.

The highway grant multiplier

One concept often used to assess the effectiveness of government
spending is the multiplier. The fiscal multiplier represents the dollar
change in economic output for each additional dollar of government
spending. Thus, a multiplier of two implies that, when government
spending increases by one dollar, output rises by two dollars.

Based on the results shown in Figure 1, we find that multipliers for
federal highway spending are large. On initial impact, the multipliers
range from 1.5 to 3, depending on the method for calculating the
multiplier. In the medium run, the multipliers can be as high as eight.
Over a 10-year horizon, our results imply an average highway grants
multiplier of about two.

Our estimated multipliers are noticeably larger than those typically
found in the literature on the effects of government spending. For
instance, in a recent survey, Valerie Ramey reports multipliers between
0.5 and 1.5 (see Ramey 2011b). One possible reason for the wide
differences is that we consider a very different form of government
spending. Most of the literature concentrates on the multiplier effect
of military spending. But such spending is arguably nonproductive in an
economic sense. By contrast, government investment in infrastructure,
such as roads, can raise the economy’s productive capacity. In that
respect, it can have a higher fiscal multiplier. Another difference is
that we concentrate on the multiplier effect on GSP, while the
literature typically studies the effect on U.S. GDP as a whole.

The American Recovery and Reinvestment Act

The deep recession of 2007–09 led to the enactment of ARRA, which
included a large one-time increase of $27.5 billion in federal highway
grants to states. ARRA was designed to have strong short-term effects.
In general, infrastructure projects are not viewed as effective forms of
short-term stimulus because of the long lags between authorization,
planning, and implementation. By the time the projects get under way, a
recession may be over. The extra spending could ultimately end up
feeding an already booming economy. To address this problem, ARRA
stipulated that state governments had to fully use their share of
federal highway grants by March 2010.

It is conceivable that highway spending during a major downturn, when
productive capacity is underutilized, may affect output in a
substantially different way than spending during more normal times. To
test this, we examined whether unanticipated changes in highway spending
in 2009 and 2010 had a different effect on GSP than in other years in
our sample. We found that spending in 2009 and 2010 was roughly four
times as large as the peak response shown in Figure 1. This suggests
that highway spending can be effective during periods of very high
economic slack, particularly when spending is structured to reduce the
usual implementation lags.

Conclusion

Surprise increases in federal investment in roads and highways appear
to have had positive effects on gross state product in both the short
and medium run. The short-run impact is akin to the traditional
Keynesian effect that stems from an increase in aggregate demand. By
contrast, the positive impact on GSP in the medium run is probably due
to supply-side effects that boost the economy’s productive capacity.
Infrastructure investment gets a good bang for the buck in the sense
that fiscal multipliers—the dollar of increased output for each dollar
of spending—are large.

Eric S. Rosengren, president of the Federal Reserve Bank of Boston, took on the
threshold versus trigger issue at some length in a Nov. 1 speech.

“I think of a trigger as a set of conditions that necessarily imply a change in
policy,” he said in the speech text. “A threshold, unlike a trigger, does not
necessarily precipitate a change in policy.”

Later he added, “A threshold precipitates a discussion and more thorough
assessment of appropriate policy, versus a trigger which starts a change of
policy.”

Why wouldn’t the Fed immediately shift policy if its thresholds for employment
and inflation were met?

Mr. Rosengren offered one example. “Suppose we reach one’s threshold
unemployment rate but at that time the economy is slowing, and no further
improvement in the unemployment rate is expected in the short to medium term,”
he wrote in the Nov. 1 speech text. “This hypothetical situation would not
necessarily imply a change in policy stance …”

Chapter 23 Monetary Policy Theory [probably won't get very far into this chapter]

Response of monetary policy to shocks

Response to an AD Shock

Response to a permanent supply shock

Response to a temporary supply shock

Summary

How active should policymakers be?

Is inflation always a monetary phenomenon?

Causes of inflationary monetary policy

Video

Extra Reading:

Tim Duy:

Yellen Supports Explicit Guideposts, by Tim Duy: Today Federal Reserve Vice Chair Janet Yellen discussed the evolution of policy communications.
As might be expected from Yellen, there was a dovish tone to the
speech. She provides a very nice overview of the Fed's changing
communication strategy before shifting to her preferred path for the
future. Along the way, she reiterates her estimated optimal path for
monetary policy:

The notable feature of the optimal path is that inflation glides to
its long-run target from above while unemployment does the opposite.
These path are achieved by holding down interest rates longer than the
level implied by a Taylor-type rule. Yellen explains that it is
challenging to communicate such a rule, particularly in the current
circumstances:

The fact that simple rules aren't as useful in current circumstances
as they would be for the FOMC at other times poses a significant
challenge for FOMC communications, especially since private-sector Fed
watchers have frequently relied on such rules to understand and predict
the Committee's decisions on the federal funds rate...

...Now, however, the federal funds rate may well diverge for a number
of years from the prescriptions of simple rules. Moreover, the FOMC
announced an open-ended asset purchase program in September, and there
is no historical record for the public to use in forming expectations on
how the FOMC is likely to use this tool. Thus, the current situation
makes it very important that the FOMC provide private-sector forecasters
with the information they need to predict how the likely path of policy
will change in response to changes in the outlook...

How can the Fed augment the current communication strategy of an
expected time frame for exceptionally low rates coupled with broad
economic objectives to be met prior to changing policy? First, more
explicit forecasts:

One logical possibility would be for the Committee to publish
forecasts akin to those I've presented in figure 1. That is, the
Committee could provide the public with its projections for inflation
and the unemployment rate together with what it views as appropriate
paths both for the federal funds rate and its asset holdings,
conditional on its current outlook for the economy.

Yellen notes, however, that the Fed's institutional structure relies
on 19 forecasts, which is challenging to synthesize into a single
forecast. Research in this area is ongoing. She then supports the basic
approach advocated by Chicago Federal Reserve President Charles Evans
and Minneapolis Federal Reserve President Narayana Kocherlakota:

Another alternative that deserves serious consideration would be for
the Committee to provide an explanation of how the calendar date
guidance included in the statement--currently mid-2015--relates to the
outlook for the economy, which can and surely will change over time.
Going further, the Committee might eliminate the calendar date entirely
and replace it with guidance on the economic conditions that would need
to prevail before liftoff of the federal funds rate might be judged
appropriate. Several of my FOMC colleagues have advocated such an
approach, and I am also strongly supportive. The idea is to define a
zone of combinations of the unemployment rate and inflation within which
the FOMC would continue to hold the federal funds rate in its current,
near-zero range.

While I like explicit targets in theory, I have been concerned that
monetary policy is too complex to summarize in two numbers, thus making
it a communications nightmare rather than a dream. Perhaps I am too
pessimistic. Yellen offers a response:

Under such an approach, liftoff would not be automatic once a
threshold is reached; that decision would require further Committee
deliberation and judgment.

Not a fixed target that requires action, just consideration of
action. Whether the rest of the FOMC follows suit with this approach is
another question, but the winds are definitely blowing in that
direction. On average then, this is relatively dovish. The Fed is
heading toward a policy direction that would explicitly allow for
inflation somewhat above target and unemployment below target as long as
inflation expectations remained anchored. One would think this should
put upward pressure on near term inflation. But Ryan Avent notes the opposite is occuring:

But since mid-October, there has been an unmistakable reversal in the
inflation-expectations trend. Based on 5-year breakevens, all of the
September spurt has been erased. And 2-year breakevens are back at July
levels. Given my optimism over the Fed's September moves and the
apparent strength of underlying fundamentals in the economy, I would
like to disregard this trend, but one should be very reluctant to
abandon guideposts that have served one well just because they've moved
in an inconvenient way.

Graphically:

Avent has a point here (with the caveat that TIPS-based inflation expectations might be less than perfect). He also expressed concern about a broader array of assets:

Other proxies for demand—equity prices, bond yields, and the level
of the dollar—have also moved, albeit modestly, in worrying ways. The
S&P 500 is down a bit over 5% from its September high, the 10-year
Treasury yield has fallen more than 20 basis points since October, and
the trade-weighted dollar, which plunged after the Fed's September
meeting, has been strengthening since the middle of last month.

I would add that Yellen's speech did not even generate a knee-jerk
response in the stock market today. I remember a time not long ago when
any hint of dovishness was good for a 1% rally. Which, combined with
Avent's thoughts, leaves me wondering if open-ended QE is the last of
the Fed's monetary tools. We now know the Fed will continuously exchange
cash for Treasury or mortgage bonds until the Fed's economic objectives
are met. Uncertainty about the course of monetary policy as been
largely eliminated. There is not likely to be a premature policy
reversal. What if the pace of the economy does not accelerate,
sustaining a large, persistent output gap and a low inflation
environment? The Fed could increase the pace of purchases, but would
this really change expectations? Can we get more "open-ended?"

Bottom Line: Yellen delivers a dovish speech, siding with Evans and
Kocherlakota who had previously advocated explicit inflation and
unemployment guidelines for policy change. The Fed is moving in this
direction, promising to further lock-in a program of aggressive large
scale asset purchases. But is this the end of the road for policy?
"Open-ended" sounds much like "unlimited." And unlimited sounds like the
end of the road. If the economy stumbles, will the Fed pull a new trick
out of its policy bag, or is that bag finally empty? And if that bag is
empty, then we will need to turn to fiscal policy if the economy
stumbles. This is worrisome given the expected path of fiscal policy -
tighter, just degrees of tighter. Which means for the moment we just
cross our fingers and hope the economy gains traction on the back of
housing and accelerates as 2013 progresses.

It's no surprise that voters in Tuesday's presidential election identified
the economy as the No. 1 issue in the campaign, far ahead of health care and the
federal budget deficit.
But it was a surprise that so many voters identified rising prices as the
biggest economic problem they face.

Linn notes something of a disconnect between this view and the facts on the
ground:

...inflation has generally been running well under 2 percent, and Federal
Reserve bankers repeatedly have said they feel comfortable that low inflation
allows them to keep interest rates at rock-bottom levels.

Yet in an exit poll of more than 25,000 voters conducted by NBC News, 37
percent identified rising prices as the biggest problem facing people like them.

Unemployment was cited by 38 percent, only slightly more than the number who
said inflation was their top economic concern. Taxes were named by 14 percent
and the housing market was the top concern of 8 percent.

The policy stakes on understanding these responses are pretty high. In the
end, the cost of inflation comes in the form of how it may distort behavior and
the allocation of resources. So the expectation or perception of significant
inflation is at least as pernicious as the measurement itself.

Over the past few years, the Federal Reserve Bank of Cleveland, with
assistance from the Ohio State University, has studied household inflation
perceptions and expectations using a monthly survey of approximately 500 Ohioans
(the FRBC/OSU Inflation Psychology Survey). This survey, which records
respondents' perceptions of price changes over the past 12 months as well as
their expectations for price changes over the next 12 months, has uncovered a
surprising result. The data indicate that the public's estimates and predictions
of inflation are significantly and systematically related to the demographic
characteristics of the respondents. People with high incomes perceive and
anticipate much less inflation than people with low incomes, married people less
than singles, whites less than nonwhites, and middle-aged people less than young
people. This Commentary describes what is perhaps the most curious observation
of all: Even after we hold constant income, age, education, race, and marital
status, men and women hold very different views on the rate at which prices are
changing.

...[S]tatistical tests reveal that even after we adjust for the respondents'
age, race, education, and income, women in our survey tended to think inflation
was 1.9 percentage points higher than men. A similar examination of respondents'
predictions of future inflation yields the same basic result: After we account
for other major demographic factors, on average, women expected prices to rise
2.1 percentage points more than men.

It is important to note that this result was not unique to the Cleveland Fed
study:

An examination of survey data collected by the University of Michigan (which
has recorded the inflation forecasts of U.S. households on a monthly basis since
1978) reveals that women consistently hold higher inflation expectations than
men, even after we hold constant other important demographic characteristics of
the respondent.

Most intriguing of all, the systematic overstatement of inflation by all
consumers, relative to official statistics, and the difference in responses
between men and women are not a result of ignorance about the facts, according
to those official statistics:

In the August 2001 FRBC/OSU survey, we sought an answer to this question by
asking, "Have you heard of the Consumer Price Index (CPI) before?" and "By about
what percentage do you think the CPI went up (or down), on average, over the
last 12 months?"

A significantly higher proportion of men had heard of the CPI compared to
women (75 percent versus 61 percent, respectively). For those who had heard of
the CPI, the average perception about how much it had risen over the past 12
months was surprisingly accurate—a perceived increase of 2.9 percent compared to
an actual increase of 2.7 percent. It is also very interesting that men and
women perceived the CPI's growth rate nearly identically (2.8 percent versus 3.1
percent, respectively.) However, of those who knew of the CPI, the average
perception of price increases was 6.7 percent. And even within the subgroup of
respondents who knew of the CPI, men had a significantly lower perception of
price increases than did women (6.0 percent vs. 7.4 percent). In other words,
the public believes that prices are rising more than the CPI reports, and women
more so than men.

There are a couple of hypotheses that could be advanced to explain results
like this. One is that the conspiracy crowd is correct and the official
statistics are rigged and vastly understate true inflation. But that wouldn't
get us anywhere near an understanding of why survey responses about inflation
would be systematically different across men and women, higher- and low- income
individuals, and just about any other demographic cuts we might make.

A second possibility it is that individuals' responses reflect price changes
in their own personal market basket, which may differ from that of
the average urban wage earner whose habits are reflected in the Consumer Price
Index (CPI).That might explain why any demographic sub group could arrive at
different inflation perceptions, but it doesn't explain why respondents as a
whole systematically overstate inflation relative to the CPI.

I think the most likely explanation is that the survey respondents are
expressing a much different concern than whether they believe food, gas, autos,
banking services, or whatever are increasing or are likely to increase faster
than the official statistics indicate. My guess is that they are telling us that
they are concerned that their real—or inflation-adjusted—incomes are
not rising fast enough to comfortably sustain their desired spending:

As I noted, the policy stakes are high. In the current environment, the
policy prescription for fighting an incipient rise in inflation expectations
would be much different than one deployed to address the reality of the chart
above. All the more reason to make sure we understand the questions we are
asking and the responses we get back.

Just to be sure, we monitor inflation trends and inflation expectations from
a number of perspectives: Treasury Inflation Protected Securities (TIPS),
forecasts, and the Business Inflation Expectations (BIE) survey, to name just
three. And all are available on the Atlanta Fed's
Inflation Project for the terminally curious to monitor with us.

but per capita employment fell by 1.8% over and above the 5.5% that was
lost during the recession.

This malaise in the US labor market has been the subject of countless
economic policy debates. The fact that employment is recovering much slower than GDP is a
relatively new phenomenon; jobless recoveries have only really occurred after
the recessions of 1991 and 2001. These last three recoveries represent a
distinct break from previous postwar episodes of recession when both GDP and
employment would vigorously rebound following recessions (Schreft and Singh
2003; Groshen and Potter 2003; Bernanke 2009).

Our current research indicates that a jobless recovery is not simply an
‘economy-wide‘ delay in firms hiring again. Instead, it can be traced to a lack
of recovery in a subset of occupations; those that focus on “routine” or
repetitive tasks that are increasingly being performed by machines (Jaimovich
and Siu 2012).

Job polarization

The fact that employment in routine occupations has been disappearing is well
documented by recent job polarization literature (Acemoglu 1999, Autor et al.
2006, Goos and Manning 2007, Goos et al. 2009, Autor and Dorn 2012). This
literature finds that occupations focused on routine tasks tend to be
middle-waged. Thus, the disappearance of routine occupations in the past 30
years represents a ‘polarization’ of employment because the middle of the wage
distribution has been hollowed out.

As recently as the mid-1980s, about one in three Americans over the age of 16
was employed in a routine occupation. Currently, that figure stands at one in
four. The fact that polarization is occurring should not surprise anyone who
understands the influence of robotics and automation on machinists and machine
operators in manufacturing. Indeed, the influence of robotics is increasingly
being felt on routine occupations in transportation and warehousing. Of equal
importance is the disappearance of routine employment in ‘white-collar’
occupations - think bank tellers being replaced by ATMs, or secretarial work
being replaced by personal computers and Siri, Apple’s iPhone-integrated
‘intelligent personal assistant’. Thus, all of the per capita employment growth
of the past 30 years has either been in ‘non-routine’ occupations located at the
high-end of the wage distribution, such as software engineers and economists, or
in low-paying jobs, such as service occupations like restaurant waiters and
janitors. For this last set of occupations, this has been especially true in the
past decade.

Jobless recoveries

What is surprising is the link between job polarization and the business
cycle. Figure 1 highlights our simple point; it plots per capita employment in
routine occupations (in log levels) from 1967 to the end of 2011. Since about
1990, there is an obvious 28 log point decline in routine employment. What is
equally clear is that this fall has not happened gradually over time but that
the decline is concentrated in economic downturns. 92% of the 28 log point fall
occurred within a 12 month window of NBER-dated recessions.

Figure 1

Following each of the 1991, 2001, and 2009 recessions, per capita employment
in routine occupations fell and never recovered. This lack of recovery in
routine employment accounts for the jobless recoveries experienced in the
aggregate. Indeed, prior to job polarization, routine job losses in recessions
were accompanied by strong routine job recoveries. This is evidenced in Figure 1
after the recessions of 1970, 1975, and 1982. Unsurprisingly, prior to job
polarization, jobless recoveries did not occur. Moreover, jobless recoveries
cannot be traced to the business cycle behavior of ‘non-routine’ jobs:
employment in these occupations experience only mild contractions, if at all,
during recessions, and have experienced essentially no change in the nature of
their recoveries over the past half century.

Explaining jobless recovery

A simple counterfactual experiment clarifies the link between job
polarization and jobless recoveries. Specifically, we ask what the recoveries in
aggregate employment would have looked like if routine employment had rebounded
as it did prior to job polarization. Would the US economy still have experienced
jobless recoveries? For the 1991, 2001, and 2009 recessions, we replace the per
capita employment in routine occupations (following the trough) with the average
recoveries following the 1970, 1975, and 1982 recessions. We then sum up the
actual employment in non-routine occupations with the counterfactual employment
in routine occupations to obtain a counterfactual aggregate employment series.

The behavior of these counterfactual series around the recent NBER recessions
is displayed in Figures 2a to 2c. The solid blue line indicates the time path of
actual per capita employment. Date 0 indicates the month in which the NBER
officially declared the end of the recession. As is clear, aggregate employment
continued to fall for many months following the end of each recession. Note that
the hatched red line represents the counterfactual series. Had employment in
routine occupations recovered as it did prior to job polarization, the US
economy would not have experienced jobless recoveries. Hence, we argue that
jobless recoveries can be attributed to the lack of recovery in routine jobs.

Figure 2

Conclusions

Structural change in the labor market is clearly manifesting itself in the
business cycle. The long-term decline in routine occupations is occurring in
spurts - employment in these jobs is lost during recessions. The reach of job
polarization is wide. Automation and the adoption of computing technology is
leading to the decline of middle-wage jobs of many stripes, both blue-collar
jobs in production and maintenance occupations and white-collar jobs in office
and administrative support. It is affecting both male- and female-dominated
professions and it is happening broadly across industries –manufacturing,
wholesale and retail trade, financial services, and even public administration.

The loss of routine jobs in recent recessions has given rise to jobless
recoveries. Aggregate employment struggles to rebound following recessions since
middle-wage, routine occupations no longer recover. Moreover, employment growth
following recent recessions has been unevenly distributed across pay,
concentrated in high- and low-wage occupations. A recent report by the National
Employment Law Project (2012) indicates that the recovery from the Great
Recession has been particularly lopsided, with the majority of jobs added being
low-paying jobs.

The pace of job polarization was greatly accelerated in this last recession,
and the pace of automation and progress in robotics and computing technology is
not slowing down either (Brynjolfsson and McAfee 2011). If the past 30 years is
any guide, we should expect future recessions to continue to spur job
polarization. Jobless recoveries may be the new norm.

References

Acemoglu, D (1999), “Changes in unemployment and wage inequality: An
alternative theory and some evidence”, American Economic Review, 89(5),
1259–1278.

Autor, D H and D Dorn (2012), “The growth of low skill service jobs and the
polarization of the U.S. labor market”, American Economic Review,
forthcoming.

Brynjolfsson, E and A McAfee (2011), Race Against The Machine: How the
Digital Revolution is Accelerating Innovation, Driving Productivity, and
Irreversibly Transforming Employment and the Economy, e-book, Digital
Frontier Press.

Goos, M and A Manning (2007), “Lousy and lovely jobs: The rising polarization
of work in Britain”, Review of Economics and Statistics, 89(1),
118–133.

If Bernanke is replaced, who is likely be the next Fed chief, and what impact will the change in leadership
have on U.S. monetary policy?

If President Barack Obama is re-elected and chooses to replace Bernanke, I believe -- as do others -- that Fed Board of Governors Vice Chairman
Janet
Yellen is the most likely nominee. Her views are close to those of Bernanke, so she would
provide the continuity that financial markets seek. She is also highly experienced, having served as president of the San Francisco Fed, and her academic
credentials are very strong. She'll be able to handle the academic heavyweights
on the bank's monetary policy committee. There are also political advantages for Obama if he appoints what would be the
first female Fed chief.

If Romney is elected, it's a different story. Economists in the Romney camp, such
as Stanford University's John Taylor, would be much more hawkish in trying to control inflation
and much more devoted to following rule-based, rather than discretionary, policy.

Taylor, a favorite among many if Romney is elected, is
responsible for the "Taylor Rule" as a guide to monetary policy. The Taylor rule links the interest rate set by
the Fed to inflation and economic output so that interest rates rise when inflation goes
up or the economy is booming, and fall when inflation is below target or the
economy falls into a recession. He has been
quite vocal in his opposition to any policy that deviates from this rule.

However, I don't think that Taylor is likely be the next Fed chair even if Romney wins, because the economist's hawkish views on monetary policy make him unlikely to survive Senate
confirmation. I also don't think there's a strong favorite to point to if Taylor is out of the picture, though two other Romney economic advisers -- Columbia University's Glenn Hubbard and Greg Mankiw of Harvard University -- are
often mentioned.

And in some ways, whomever is likely to get the nod in a Romney administration isn't that important, since that person is sure to
have views that move policy in the direction that Taylor would favor.

But no matter who is in control of the Fed, in normal times policy is likely
to be conducted much as the Taylor rule describes -- that was certainly true
before the Great Recession. It's during abnormal times, as we've
just experienced, when there is reason to abandon Taylor's approach and the differences in policy would emerge.

What would that mean for monetary policy? A Fed led by Taylor or
someone with his views would be much less likely to react aggressively during a
downturn or to implement bank bailouts, and much more likely to pursue a fast exit
from any stimulative policies. For example, if Taylor had his way, the Fed already would have raised interest
rates by now and would be backing off
quantitative easing rather than implementing another round (if it ever pursued
such a policy in the first place).

However, I don't want to overemphasize the differences even during unusual
economic times. It's easy to criticize the Fed from the outside, and to proclaim
that central bankers should stand up to the pressure not to bailout a troubled financial
system. But when you are the Fed chair and it's your reputation on
the line -- when people's livelihoods depend on your decisions, when the
choice is between letting big banks fail and risking a complete blowout of the
financial system -- or taking action known to stabilize the financial
system, even hawkish chairs are likely to act.

After all, the bank bailout,
though widely attributed to Obama, actually came under George W. Bush's presidency and was enacted with Republican support. If another financial meltdown happens, Fed action is
likely no matter how much tough talk there's been in the past.

There's another reason to expect current policy to continue, at least
initially, even if Fed leadership changes. The Fed chair, though very
powerful, must still command a majority of votes on the bank's monetary policy
committee in order to control policy. If the Fed chair proposes a radical
departure from present policy, it is unlikely to be approved. Over time, as
current Fed members' terms expire or they voluntarily step down, a president can
shape the committee and policy through new appointment. But a new Fed chief
would have a lot of trouble completely altering the course of policy on day one.

Of course, who wins the presidential election still matters. It shapes how
aggressive and persistent monetary policy will be in combating unemployment,
particularly during a severe recession. It also matters for another critical aspect
of policy -- bank regulation. A Fed chair appointed by Obama would be much
more likely to pursue strict regulation of banks than a Fed led by a Romney
appointee. For those who believe that our current troubles are due, at least in
part, to the failure to regulate the banking system, this is no small difference.

Credit Access Following a Mortgage Default, by William Hedberg and John Krainer, FRBSF Economic Letter: Borrowers who default on mortgages return to the mortgage market
at extremely slow rates. Only about 10% of borrowers with a prior
serious delinquency regain access to the mortgage market within 10 years
of their default. Borrowers who terminate mortgages for reasons other
than default return to the market about two-and-a-half times faster than
those who default. Renewed access to credit takes even longer for
subprime borrowers with a serious delinquency on their record. [more here]

... One parallel to consider is the devastation from Hurricane Katrina in 2005.
In addition to the short-run dislocations, this ended up causing
lasting damage to offshore oil-producing infrastructure. An optimist might
have thought this would create all kinds of new jobs trying to rebuild. The
actual experience was not so cheerful.

The
Wall Street Journal reports that IHS estimates that Hurricane Sandy
could
reduce the 2012:Q4 U.S. real GDP growth rate by 0.6 percentage points at
an
annual rate. I'm not sure how one comes up with that kind of number. But
I am persuaded this was not a good thing for the U.S. economy.